Technical Line FASB final guidance

Transcription

1 No March 2016 Technical Line FASB final guidance A closer look at the new leases standard The new leases standard requires lessees to recognize most leases on their balance sheets. What you need to know The FASB issued final guidance that requires lessees to put most leases on their balance sheets but recognize expenses on their income statements in a manner similar to today s accounting. For lessors, the guidance modifies the lease classification criteria and the accounting for sales-type and direct financing leases. The guidance also eliminates today s real estate-specific provisions for all entities. All entities classify leases to determine how to recognize lease-related revenue and expense. Classification continues to affect what lessors record on the balance sheet. For calendar-year public business entities and certain calendar-year not-for-profit entities and employee benefit plans, the guidance is effective in 2019 and interim periods within that year. For other calendar-year entities, it is effective in 2020, and interim periods in Early adoption is permitted for all entities. Overview The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) , Leases, that requires lessees to recognize assets and liabilities for most leases. This could have broad implications for entities finances and operations. Entities should plan to explain the effects of the adopting the new leases standard to stakeholders, including making disclosures discussed in the US Securities and Exchange Commission (SEC) Staff Accounting Bulletin Topic 11.M. Implementing the standard also could require an entity to develop new processes and controls or adjust existing ones to identify and account for leases.

2 The FASB issued the guidance in February 2016 after joint deliberations with the International Accounting Standards Board (IASB), which issued a similar standard (IFRS 16, Leases). However, there are significant differences between the FASB and IASB standards (e.g., lessees do not classify leases under IFRS and can elect to account for leases of low-value assets under a model similar to today s operating leases). These differences will result in certain transactions being accounted for differently under US GAAP and IFRS. The current lease accounting guidance in Accounting Standards Codification (ASC) 840, Leases, has been criticized for failing to meet the needs of users of the financial statements, particularly because it doesn t require lessees to recognize assets and liabilities arising from operating leases. The new guidance that is codified in ASC 842, Leases, addresses those criticisms by requiring lessees to recognize most leases on their balance sheets and providing enhanced disclosures. The FASB believes this will result in a more faithful representation of lessees assets and liabilities and greater transparency about the lessees obligations and leasing activities. Under ASC 842, leases are accounted for based on what the FASB refers to as a right-of-use model. The model reflects that, at the commencement date, a lessee has a financial obligation to make lease payments to the lessor for its right to use the underlying asset during the lease term. The lessor conveys that right to use the underlying asset at lease commencement, which is the point in time when it makes the underlying asset available for use by the lessee. Entities will need to focus on whether an arrangement contains a lease or a service agreement because there are significant differences in the accounting. Although ASC 842 changes how the definition of a lease is applied, we believe that the assessment of whether a contract contains a lease will be straightforward in most arrangements. However, judgment may be required in applying the definition of a lease to certain arrangements, particularly those that include significant services. ASC 842 requires lessees to classify most leases as either finance or operating leases. Lessors classify all leases as sales-type, direct financing or operating leases. While ASC 842 and ASC 840 use the same or similar terms for lease types for lessees and lessors, lease classification under the two standards could differ because the classification tests are not identical. ASC 842 eliminates ASC 840 s bright lines (e.g., the 75% of economic life and 90% of fair value tests) and modifies the lessor classification criteria. The guidance also eliminates ASC 840 s real estate-specific provisions for lessees and lessors. Lease classification is important in determining how and when a lessee and a lessor recognize lease expense and revenue, respectively, and what assets a lessor records. For lessees, the income statement presentation and expense recognition pattern for finance leases is similar to that of today s capital leases (i.e., separate interest and amortization expense with higher periodic expense in the earlier periods of a lease). For operating leases, the income statement presentation and expense recognition pattern is similar to that of ASC 840 s operating leases (i.e., a single lease cost is generally recognized on a straight-line basis). ASC 842 does not make fundamental changes to today s lessor accounting model. However, the guidance modifies what qualifies as a sales-type and direct financing lease as well as the related accounting. 2 Technical Line A closer look at the new leases standard 31 March 2016

3 ASU is effective for public business entities (PBEs) 1 and certain not-for-profit entities and employee benefit plans 2 for annual periods beginning after 15 December 2018 (i.e., 1 January 2019 for a calendar-year entity), and interim periods within those years. For all other entities, it is effective for annual periods beginning after 15 December 2019 (i.e., 1 January 2020 for a calendar-year entity), and interim periods the following year. Early adoption is permitted for all entities. ASU s transition provisions are applied using a modified retrospective approach at the beginning of the earliest comparative period presented in the financial statements. For example, a calendar-year entity that adopts ASU as of 1 January 2019 and presents three years of financial statements applies the transition provisions to the period beginning 1 January Full retrospective application is prohibited. This publication discusses how ASU is applied and is intended to help companies consider the effects of adopting it. We encourage preparers and users of financial statements to read this publication carefully and consider the potential effects of the new standard. The views we express in this publication represent our perspectives as of March We may identify additional issues as we analyze the standard and entities begin to interpret it, and our views may evolve during that process. 1 See the ASC Master Glossary for the definition of a public business entity. 2 Not-for-profit entities that have issued, or are conduit bond obligors for, securities that are traded, listed or quoted on an exchange or an over-the-counter market and employee benefit plans that file or furnish financial statements with or to the SEC. 3 Technical Line A closer look at the new leases standard 31 March 2016

4 Contents 1 Scope and scope exceptions General Determining whether an arrangement contains a lease Reassessment of the contract Identifying and separating lease and non-lease components of a contract and allocating contract consideration Contract combinations Key concepts Inception of a contract Commencement date of the lease Lease term and purchase options Lease payments Discount rates Initial direct costs Economic life Fair value Related party leasing transactions Lease classification Criteria for lease classification lessees Criteria for lease classification lessors Discount rates used to determine lease classification Lease classification considerations Comparison of the lease classification tests in ASC 842 and ASC Reassessment of lease classification Lessee accounting Initial recognition Operating leases Finance leases Remeasurement of lease liabilities and right-of-use assets Lease modifications Other lessee matters Presentation Disclosure Lessor accounting Lessor accounting concepts Sales-type leases Direct financing leases Operating leases Examples lessor accounting Lease modifications Other lessor matters Presentation Disclosure Technical Line A closer look at the new leases standard 31 March 2016

5 6 Subleases Definition Original lessor accounting Sublessor accounting Sublessee accounting Disclosure Sale and leaseback transactions Determining whether the transfer of an asset is a sale Transactions in which the transfer of an asset is a sale Transactions in which the transfer of an asset is not a sale Lessee involvement in asset construction ( build-to-suit transactions) Disclosure Business combinations Classification of acquired leases Initial recognition Initial and subsequent measurement Effective date and transition Effective date Transition Lessee transition Lessor transition Other considerations Disclosures Appendix A: Illustrations from ASC 842 on the application of the definition of a lease A1 Example 1 Rail cars A2 Example 2 Concession space A3 Example 3 Fiber-optic cable A4 Example 4 Retail unit A5 Example 5 Truck rental A6 Example 6 Ship A7 Example 7 Aircraft A8 Example 8 Contract for shirts A9 Example 9 Contract for energy/power A10 Example 10 Contract for network services Appendix B: Summary of lease reassessment and remeasurement requirements Appendix C: Summary of accounting for lease modifications lessees Appendix D: Summary of accounting for lease modifications lessors Portions of FASB publications reprinted with permission. Copyright Financial Accounting Standards Board, 401 Merritt 7, P.O. Box 5116, Norwalk, CT , U.S.A. 5 Technical Line A closer look at the new leases standard 31 March 2016

6 1 Scope and scope exceptions 1.1 General Leases Overall Scope and Scope Exceptions An entity shall apply this Topic to all leases, including subleases. Because a lease is defined as a contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration, this Topic does not apply to any of the following: a. Leases of intangible assets (see Topic 350, Intangibles Goodwill and Other). The scope of ASC 842 is limited to leases of property, plant and equipment, including subleases of those assets. b. Leases to explore for or use minerals, oil, natural gas, and similar nonregenerative resources (see Topics 930, Extractive Activities Mining, and 932, Extractive Activities Oil and Gas). This includes the intangible right to explore for those natural resources and rights to use the land in which those natural resources are contained (that is, unless those rights of use include more than the right to explore for natural resources), but not equipment used to explore for the natural resources. c. Leases of biological assets, including timber (see Topic 905, Agriculture). d. Leases of inventory (see Topic 330, Inventory). e. Leases of assets under construction (see Topic 360, Property, Plant, and Equipment). Consistent with ASC 840, the scope of ASC 842 is limited to leases of property, plant and equipment (i.e., land and depreciable assets), including subleases of those assets. ASC 842 does not apply to any of the following: Leases of intangible assets Leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources, including the intangible rights to explore for those natural resources and rights to use the land in which those natural resources are contained (unless those rights of use include more than the right to explore for natural resources), but not equipment used to explore for the natural resources Leases of biological assets, including timber Leases of inventory Leases of assets under construction (refer to section 7.4, Lessee involvement in asset construction ( build-to-suit transactions)) Service concession arrangements Service concession arrangements 3 in the scope of ASC 853, Service Concession Arrangements, are excluded from the scope of ASC 842. Entities should evaluate the applicability of ASC 853 before evaluating whether an arrangement contains a lease. 3 A service concession arrangement is an arrangement between a public-sector entity grantor and an operating entity under which the operating entity generally operates the grantor s infrastructure (e.g., an airport, road, bridge, tunnel) for a specified period of time. Refer to our Financial reporting developments publication, Lease accounting, for further information. 6 Technical Line A closer look at the new leases standard 31 March 2016

7 1.2 Determining whether an arrangement contains a lease Master Glossary Lease A contract, or part of a contract, that conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. Contract An agreement between two or more parties that creates enforceable rights and obligations. Period of Use The total period of time that an asset is used to fulfill a contract with a customer (including the sum of any nonconsecutive periods of time). Leases Overall Scope and Scope Exceptions At inception of a contract, an entity shall determine whether that contract is or contains a lease A contract is or contains a lease if the contract conveys the right to control the use of identified property, plant, or equipment (an identified asset) for a period of time in exchange for consideration. A period of time may be described in terms of the amount of use of an identified asset (for example, the number of production units that an item of equipment will be used to produce) To determine whether a contract conveys the right to control the use of an identified asset (see paragraphs through 15-26) for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following: a. The right to obtain substantially all of the economic benefits from use of the identified asset (see paragraphs through 15-19) b. The right to direct the use of the identified asset (see paragraphs through 15-26). If the customer in the contract is a joint operation or a joint arrangement, an entity shall consider whether the joint operation or joint arrangement has the right to control the use of an identified asset throughout the period of use If the customer has the right to control the use of an identified asset for only a portion of the term of the contract, the contract contains a lease for that portion of the term In making the determination about whether a contract is or contains a lease, an entity shall consider all relevant facts and circumstances. 7 Technical Line A closer look at the new leases standard 31 March 2016

8 A lease is a contract (i.e., an agreement between two or more parties that creates enforceable rights and obligations), or part of a contract, that conveys the right to control the use of identified property, plant or equipment (i.e., an identified asset) for a period of time in exchange for consideration. ASC 842 requires an entity to determine whether a contract is a lease or contains a lease at the inception of the contract, considering all relevant facts and circumstances Identified asset Leases Overall Scope and Scope Exceptions An asset typically is identified by being explicitly specified in a contract. However, an asset also can be identified by being implicitly specified at the time that the asset is made available for use by the customer. An identified asset can be a physically distinct portion of a larger asset A capacity portion of an asset is an identified asset if it is physically distinct (for example, a floor of a building or a segment of a pipeline that connects a single customer to the larger pipeline). A capacity or other portion of an asset that is not physically distinct (for example, a capacity portion of a fiber optic cable) is not an identified asset, unless it represents substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset. The requirement that there be an identified asset is fundamental to the definition of a lease. This concept is generally consistent with the specified asset concept in ASC 840. Under ASC 842, an identified asset can be either implicitly or explicitly specified in a contract. Illustration 1 Implicitly specified asset Customer X enters into a five-year contract with Supplier Y for the use of a rail car specifically designed for Customer X. The rail car is designed to transport materials used in Customer X s production process and is not suitable for use by other customers. The rail car is not explicitly specified in the contract, but Supplier Y owns only one rail car that is suitable for Customer X s use. If the rail car does not operate properly, the contract requires Supplier Y to repair or replace the rail car. Assume that Supplier Y does not have a substantive substitution right (refer to section , Substantive substitution rights). Analysis: The rail car is an identified asset. While the rail car is not explicitly specified in the contract (e.g., by serial number), it is implicitly specified because Supplier Y must use it to fulfill the contract. An identified asset also can be a physically distinct portion of a larger asset. Examples include a floor of a building, the last mile of a telecommunications network that connects a single customer to a larger network or a segment of a pipeline that connects a single customer to a larger pipeline (i.e., the segment is used solely by one customer). However, a capacity portion or other portion of an asset that is not physically distinct (e.g., a capacity portion of a fiber optic cable) is not an identified asset unless it represents substantially all of the capacity of the asset and thereby provides the customer with the right to obtain substantially all of the economic benefits from use of the asset. 8 Technical Line A closer look at the new leases standard 31 March 2016

9 How we see it The term substantially all is not defined in ASC 842. However, entities might refer to ASC s description of how substantially all of the fair value of the underlying asset could be evaluated in the context of lease classification. In that paragraph, the FASB states that one reasonable approach would be to conclude that [n]inety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset. Illustration 2 Identified asset physically distinct portion of a larger asset Customer X enters into a 12-year contract with Supplier Y for the right to use three fibers within a fiber optic cable between New York and London. The contract identifies three of the cable s 20 fibers for use by Customer X. The three fibers are dedicated solely to Customer X s data for the duration of the contract term. Assume that Supplier Y does not have a substantive substitution right (refer to section , Substantive substitution rights). Analysis: The three fibers are identified assets because they are physically distinct and explicitly specified in the contract. Illustration 3 Identified asset capacity portion of an asset Scenario A Customer X enters into a five-year contract with Supplier Y for the right to transport oil from west Texas to Houston through Supplier Y s pipeline. The contract provides that Customer X will have the use of 95% of the pipeline s capacity throughout the term of the arrangement. Analysis: The capacity portion of the pipeline is an identified asset. While 95% of the pipeline s capacity is not physically distinct from the remaining capacity of the pipeline, it represents substantially all of the capacity of the pipeline and thereby provides Customer X with the right to obtain substantially all of the economic benefits from use of the pipeline. Scenario B Assume the same facts as in Scenario A, except that Customer X has the right to use 60% of the pipeline s capacity throughout the term of the arrangement. Analysis: The capacity portion of the pipeline is not an identified asset because 60% of the pipeline s capacity is less than substantially all of the capacity of the pipeline. Customer X does not have the right to obtain substantially all of the economic benefits from use of the pipeline. 9 Technical Line A closer look at the new leases standard 31 March 2016

10 Substantive substitution rights Leases Overall Scope and Scope Exceptions Even if an asset is specified, a customer does not have the right to use an identified asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier s right to substitute an asset is substantive only if both of the following conditions exist: a. The supplier has the practical ability to substitute alternative assets throughout the period of use (for example, the customer cannot prevent the supplier from substituting an asset, and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time). b. The supplier would benefit economically from the exercise of its right to substitute the asset (that is, the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset) An entity s evaluation of whether a supplier s substitution right is substantive is based on facts and circumstances at inception of the contract and shall exclude consideration of future events that, at inception, are not considered likely to occur. Examples of future events that, at inception of the contract, would not be considered likely to occur and, thus, should be excluded from the evaluation include, but are not limited to, the following: a. An agreement by a future customer to pay an above-market rate for use of the asset b. The introduction of new technology that is not substantially developed at inception of the contract c. A substantial difference between the customer s use of the asset, or the performance of the asset and the use or performance considered likely at inception of the contract d. A substantial difference between the market price of the asset during the period of use and the market price considered likely at inception of the contract If the asset is located at the customer s premises or elsewhere, the costs associated with substitution are generally higher than when located at the supplier s premises and, therefore, are more likely to exceed the benefits associated with substituting the asset If the supplier has a right or an obligation to substitute the asset only on or after either a particular date or the occurrence of a specified event, the supplier does not have the practical ability to substitute alternative assets throughout the period of use The supplier s right or obligation to substitute an asset for repairs or maintenance, if the asset is not operating properly, or if a technical upgrade becomes available, does not preclude the customer from having the right to use an identified asset If the customer cannot readily determine whether the supplier has a substantive substitution right, the customer shall presume that any substitution right is not substantive. 10 Technical Line A closer look at the new leases standard 31 March 2016

11 Even if an asset is specified, a customer does not have the right to use an identified asset if, at inception of the contract, a supplier has the substantive right to substitute the asset throughout the period of use (i.e., the total period of time that an asset is used to fulfill a contract with a customer, including the sum of any nonconsecutive periods of time). A substitution right is substantive when both of the following conditions are met: The supplier has the practical ability to substitute alternative assets throughout the period of use (e.g., the customer cannot prevent the supplier from substituting an asset and alternative assets are readily available to the supplier or could be sourced by the supplier within a reasonable period of time). The supplier would benefit economically from the exercise of its right to substitute the asset (i.e., the economic benefits associated with substituting the asset are expected to exceed the costs associated with substituting the asset). The FASB indicated in the Background Information and Basis for Conclusions (BC 129) that the conditions above are intended to differentiate between substitution rights that result in a supplier controlling the use of an asset, rather than the customer, and rights that do not change the substance or character of the contract. An entity s evaluation of whether a supplier s substitution right is substantive is based on facts and circumstances at inception of the contract. At inception of the contract, an entity should not consider future events that are not likely to occur. ASC 842 provides the following examples of circumstances that at inception of the contract are not likely to occur and thus are excluded from the evaluation of whether a supplier s substitution right is substantive throughout the period of use: An agreement by a future customer to pay an above-market rate for use of the asset The introduction of new technology that is not substantially developed at inception of the contract A substantial difference between the customer s use of the asset, or the performance of the asset, and the use or performance considered likely at inception of the contract A substantial difference between the market price of the asset during the period of use and the market price considered likely at inception of the contract The requirement that a substitution right must benefit the supplier economically in order to be substantive is a new concept. The FASB indicated in the Basis for Conclusions (BC 130) that in many cases it will be clear that the supplier will not benefit from the exercise of a substitution right because of the costs associated with substituting an asset. The physical location of the asset may affect the costs associated with substituting the asset. For example, if an asset is located at the customer s premises, the cost associated with substituting it is generally higher than the cost of substituting a similar asset located at the supplier s premises. However, simply because a supplier concludes that the cost of substitution is not significant doesn t automatically mean that it would economically benefit from the right of substitution. ASC further clarifies that a customer should presume that a supplier s substitution right is not substantive when the customer cannot readily determine whether the supplier has a substantive substitution right. This requirement is intended to clarify that a customer is not expected to exert undue effort to provide evidence that a substitution right is not substantive. We believe that the FASB did not include a similar provision for suppliers because they should have sufficient information to make a determination of whether a substitution right is substantive. 11 Technical Line A closer look at the new leases standard 31 March 2016

12 Contract terms that allow or require a supplier to substitute alternative assets only when the underlying asset is not operating properly (e.g., a normal warranty provision) or when a technical upgrade becomes available do not create a substantive substitution right. A supplier s right or obligation to substitute alternative assets only on or after a particular date or the occurrence of a specified event also does not create a substantive substitution right because the supplier does not have the practical ability to substitute alternative assets throughout the period of use. Illustration 4 Substitution rights Scenario A A lease conveys the right to control the use of identified property, plant or equipment for a period of time in exchange for consideration. Assume that an electronic data storage provider (supplier) provides services, through a centralized data center, that involve the use of a specified server (Server No. 9). The supplier maintains many identical servers in a single, accessible location and determines, at inception of the contract, that it is permitted to and can easily substitute another server without the customer s consent throughout the period of use. Further, the supplier would benefit economically from substituting an alternative asset, because doing this would allow the supplier to optimize the performance of its network at only a nominal cost. In addition, the supplier has made clear that it has negotiated this right of substitution as an important right in the arrangement, and the substitution right affected the pricing of the arrangement. Analysis: The customer does not have the right to use an identified asset because, at the inception of the contract, the supplier has the practical ability to substitute the server and would benefit economically from such a substitution. However, if the customer could not readily determine whether the supplier had a substantive substitution right (e.g., there is insufficient transparency into the supplier s operations), the customer would presume the substitution right is not substantive and conclude that there is an identified asset. Scenario B Assume the same facts as in Scenario A except that Server No. 9 is customized, and the supplier does not have the practical ability to substitute the customized asset throughout the period of use. Additionally, it is unclear whether the supplier would benefit economically from sourcing a similar alternative asset. Analysis: Because the supplier does not have the practical ability to substitute the asset, and there is no evidence of economic benefit to the supplier for substituting the asset, the substitution right is non-substantive, and Server No. 9 would be an identified asset. In this case, neither of the conditions of a substantive substitution right is met. As a reminder, both conditions must be met for the supplier to have a substantive substitution right Right to control the use of the identified asset A contract conveys the right to control the use of an identified asset for a period of time if, throughout the period of use, the customer has both of the following: The right to obtain substantially all of the economic benefits from the use of the identified asset (see section , Right to obtain substantially all of the economic benefits from the use of the identified asset) The right to direct the use of the identified asset (see section , Right to direct the use of the identified asset) If the customer has the right to control the use of an identified asset for only a portion of the term of the contract, the contract contains a lease for that portion of the term in accordance with ASC Technical Line A closer look at the new leases standard 31 March 2016

13 Right to obtain substantially all of the economic benefits from the use of the identified asset Leases Overall Scope and Scope Exceptions To control the use of an identified asset, a customer is required to have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use (for example, by having exclusive use of the asset throughout that period). A customer can obtain economic benefits from use of an asset directly or indirectly in many ways, such as by using, holding, or subleasing the asset. The economic benefits from use of an asset include its primary output and by-products (including potential cash flows derived from these items) and other economic benefits from using the asset that could be realized from a commercial transaction with a third party When assessing the right to obtain substantially all of the economic benefits from use of an asset, an entity shall consider the economic benefits that result from use of the asset within the defined scope of a customer s right to use the asset in the contract (see paragraph ). For example: a. If a contract limits the use of a motor vehicle to only one particular territory during the period of use, an entity shall consider only the economic benefits from use of the motor vehicle within that territory and not beyond. b. If a contract specifies that a customer can drive a motor vehicle only up to a particular number of miles during the period of use, an entity shall consider only the economic benefits from use of the motor vehicle for the permitted mileage and not beyond If a contract requires a customer to pay the supplier or another party a portion of the cash flows derived from use of an asset as consideration, those cash flows paid as consideration shall be considered to be part of the economic benefits that the customer obtains from use of the asset. For example, if a customer is required to pay the supplier a percentage of sales from use of retail space as consideration for that use, that requirement does not prevent the customer from having the right to obtain substantially all of the economic benefits from use of the retail space. That is because the cash flows arising from those sales are considered to be economic benefits that the customer obtains from use of the retail space, a portion of which it then pays to the supplier as consideration for the right to use that space. A customer s right to control the use of an identified asset depends on its right to obtain substantially all of the economic benefits from the use of the identified asset throughout the period of use. The term substantially all is not defined in ASC 842. Refer to section 1.2.1, Identified asset, for a discussion about how an entity might evaluate this term. A customer can obtain economic benefits either directly or indirectly (e.g., by using, holding or subleasing the asset). Economic benefits include the asset s primary outputs (i.e., goods or services) and any byproducts (e.g., renewable energy credits that are generated through the use of the asset), including potential cash flows derived from these items. Economic benefits also include benefits from using the asset that could be realized from a commercial transaction with a third party. However, economic benefits arising from ownership of the identified asset (e.g., tax benefits related to excess tax depreciation and investment tax credits) are not 13 Technical Line A closer look at the new leases standard 31 March 2016

14 considered economic benefits derived from the use of the asset and therefore are not considered when assessing whether a customer has the right to obtain substantially all the economic benefits. When assessing whether the customer has the right to obtain substantially all the economic benefits from the use of an asset, an entity must consider the economic benefits that result from the use of the asset within the defined scope of the customer s right to use the asset. A right that solely protects the supplier s interest in the underlying asset (e.g., limits on the number of miles a customer can drive a supplier s vehicle) does not, in and of itself, prevent the customer from obtaining substantially all of the economic benefits from the use of the asset (refer to section , Protective rights). Instead, it simply limits the economic benefits that are to be evaluated. If a contract requires a customer to pay the supplier or another party a portion of the cash flows derived from the use of an asset as consideration (e.g., a percentage of sales from the use of retail space), those cash flows are considered to be economic benefits that the customer derives from the use of the asset Right to direct the use of the identified asset Leases Overall Scope and Scope Exceptions A customer has the right to direct the use of an identified asset throughout the period of use in either of the following situations: a. The customer has the right to direct how and for what purpose the asset is used throughout the period of use (as described in paragraphs through 15-26). b. The relevant decisions about how and for what purpose the asset is used are predetermined (see paragraph ) and at least one of the following conditions exists: 1. The customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use without the supplier having the right to change those operating instructions. 2. The customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use The relevant decisions about how and for what purpose an asset is used can be predetermined in a number of ways. For example, the relevant decisions can be predetermined by the design of the asset or by contractual restrictions on the use of the asset. Requiring a customer to have the right to direct the use of an identified asset is a change from ASC 840. A contract may have met ASC 840 s control criterion if, for example, the customer obtained substantially all of the output of an underlying asset and met certain price-per-unitof-output criteria even though the customer did not have the right to direct the use of the identified asset as contemplated by ASC 842. Under ASC 842, such arrangements would no longer be considered leases. 14 Technical Line A closer look at the new leases standard 31 March 2016

15 A customer has the right to direct the use of an identified asset throughout the period of use when either: The customer has the right to direct how and for what purpose the asset is used throughout the period of use. The relevant decisions about how and for what purpose the asset is used are predetermined and the customer either (1) has the right to operate the asset, or direct others to operate the asset in a manner it determines, throughout the period of use without the supplier having the right to change the operating instructions or (2) designed the asset, or specific aspects of the asset, in a way that predetermines how and for what purpose the asset will be used throughout the period of use. The right to direct how and for what purpose an asset is used throughout the period of use Leases Overall Scope and Scope Exceptions A customer has the right to direct how and for what purpose an asset is used throughout the period of use if, within the scope of its right of use defined in the contract, it can change how and for what purpose the asset is used throughout that period. In making this assessment, an entity considers the decision-making rights that are most relevant to changing how and for what purpose an asset is used throughout the period of use. Decision-making rights are relevant when they affect the economic benefits to be derived from use. The decision-making rights that are most relevant are likely to be different for different contracts, depending on the nature of the asset and the terms and conditions of the contract Examples of decision-making rights that, depending on the circumstances, grant the right to direct how and for what purpose an asset is used, within the defined scope of the customer s right of use, include the following: a. The right to change the type of output that is produced by the asset (for example, deciding whether to use a shipping container to transport goods or for storage, or deciding on the mix of products sold from a retail unit) b. The right to change when the output is produced (for example, deciding when an item of machinery or a power plant will be used) c. The right to change where the output is produced (for example, deciding on the destination of a truck or a ship or deciding where a piece of equipment is used or deployed) d. The right to change whether the output is produced and the quantity of that output (for example, deciding whether to produce energy from a power plant and how much energy to produce from that power plant) Examples of decision-making rights that do not grant the right to direct how and for what purpose an asset is used include rights that are limited to operating or maintaining the asset. Although rights such as those to operate or maintain an asset often are essential to the efficient use of an asset, they are not rights to direct how and for what purpose the asset is used and often are dependent on the decisions about how and for what purpose the 15 Technical Line A closer look at the new leases standard 31 March 2016

16 asset is used. Such rights (that is, to operate or maintain the asset) can be held by the customer or the supplier. The supplier often holds those rights to protect its investment in the asset. However, rights to operate an asset may grant the customer the right to direct the use of the asset if the relevant decisions about how and for what purpose the asset is used are predetermined (see paragraph (b)(1)). A customer has the right to direct the use of an identified asset whenever it has the right to direct how and for what purpose the asset is used throughout the period of use (i.e., it can change how and for what purpose the asset is used throughout the period of use). How and for what purpose an asset is used is a single concept (i.e., how an asset is used is not assessed separately from for what purpose an asset is used). When evaluating whether a customer has the right to direct how and for what purpose the asset is used throughout the period of use, the focus should be on whether the customer has the decision-making rights that will most affect the economic benefits that will be derived from the use of the asset. The decision-making rights that are most relevant are likely to depend on the nature of the asset and the terms and conditions of the contract. The FASB indicated in the Basis for Conclusions (BC 137) that decisions about how and for what purpose an asset is used can be viewed as similar to the decisions made by a board of directors. Decisions made by a board of directors about the operating and financing activities of an entity are generally the most relevant decisions rather than the actions of individuals in implementing those decisions. ASC 842 provides the following examples of decision-making rights that grant the right to change how and for what purpose an asset is used: The right to change the type of output that is produced by the asset (e.g., deciding whether to use a shipping container to transport goods or for storage, deciding on the mix of products sold from a retail unit) The right to change when the output is produced (e.g., deciding when an item of machinery or a power plant will be used) The right to change where the output is produced (e.g., deciding on the destination of a truck or a ship, deciding where a piece of equipment is used or deployed) The right to change whether the output is produced and the quantity of that output (e.g., deciding whether to produce energy from a power plant and how much energy to produce from that power plant) ASC 842 also provides the following examples of decision-making rights that do not grant the right to change how and for what purpose an asset is used: Maintaining the asset Operating the asset Although the decisions about maintaining and operating the asset are often essential to the efficient use of that asset, the right to make those decisions, in and of itself, does not result in the right to change how and for what purpose the asset is used throughout the period of use. The customer does not need the right to operate the underlying asset to have the right to direct its use. That is, the customer may direct the use of an asset that is operated by the supplier s personnel. However, as discussed below, the right to operate an asset will often provide the customer the right to direct the use of the asset if the relevant decisions about how and for what purpose the asset is used are predetermined. 16 Technical Line A closer look at the new leases standard 31 March 2016

17 How we see it We believe that the assessment of whether a contract is or contains a lease will be straightforward in most arrangements. However, judgment may be required in applying the definition of a lease to certain arrangements. For example, in contracts that include significant services, we believe that determining whether the contract conveys the right to direct the use of an identified asset may be challenging. The relevant decisions about how and for what purpose an asset is used are predetermined Determining when a customer has the right to direct the use of the identified asset may be more complex when an arrangement contains a significant service component. In some cases, it will not be clear whether the customer has the right to direct the use of the identified asset. This could be the case when the most relevant decisions about how and for what purpose an asset is used are predetermined by contractual restrictions on the use of the asset (e.g., the decisions about the use of the asset are agreed to by the customer and the supplier in negotiating the contract, and those decisions cannot be changed). This could also be the case when the most relevant decisions about how and for what purpose an asset is used are, in effect, predetermined by the design of the asset. The FASB indicated in the Basis for Conclusions (BC 138) that it would expect decisions about how and for what purpose an asset is used to be predetermined in few cases. In such cases, a customer has the right to direct the use of an identified asset throughout the period of use when the customer either: Has the right to operate the asset, or direct others to operate the asset in a manner it determines, throughout the period of use without the supplier having the right to change those operating instructions Designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use Significant judgment may be required to assess whether a customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use. See Example 9 in Appendix A, Illustrations from ASC 842 on the application of the definition of a lease, for an example of the evaluation of whether a customer designed the asset in a way that predetermines how and for what purpose the asset will be used throughout the period of use. Specifying the output of an asset before the period of use Leases Overall Scope and Scope Exceptions In assessing whether a customer has the right to direct the use of an asset, an entity shall consider only rights to make decisions about the use of the asset during the period of use unless the customer designed the asset (or specific aspects of the asset) in accordance with paragraph (b)(2). Consequently, unless that condition exists, an entity shall not consider decisions that are predetermined before the period of use. For example, if a customer is able only to specify the output of an asset before the period of use, the customer does not have the right to direct the use of that asset. The ability to specify the output in a contract before the period of use, without any other decision-making rights relating to the use of the asset, gives a customer the same rights as any customer that purchases goods or services. If a customer can only specify the output from an asset before the beginning of the period of use and cannot change that output throughout the period of use, the customer does not have the right to direct the use of that asset unless it designed the asset, or specific aspects of the 17 Technical Line A closer look at the new leases standard 31 March 2016

18 asset, as contemplated in ASC (b)(2). If the customer did not design the asset or aspects of it, the customer s ability to specify the output in a contract that doesn t give it any other relevant decision-making rights relating to the use of the asset (e.g., the ability to change when, whether and what output is produced) gives the customer the same rights as any customer that purchases goods or services in a service arrangement (i.e., a contract that does not contain a lease) Protective rights Leases Overall Scope and Scope Exceptions A contract may include terms and conditions designed to protect the supplier s interest in the asset or other assets, to protect its personnel, or to ensure the supplier s compliance with laws or regulations. These are examples of protective rights. For example, a contract may specify the maximum amount of use of an asset or limit where or when the customer can use the asset, may require a customer to follow particular operating practices, or may require a customer to inform the supplier of changes in how an asset will be used. Protective rights typically define the scope of the customer s right of use but do not, in isolation, prevent the customer from having the right to direct the use of an asset. A supplier s protective rights, in isolation, do not prevent the customer from having the right to direct the use of an identified asset. Protective rights typically define the scope of the customer s right to use the asset without removing the customer s right to direct the use of the asset. Protective rights are intended to protect a supplier s interests (e.g., interests in the asset, its personnel, compliance with laws and regulations) and might take the form of a specified maximum amount of asset use, a restriction on where an asset may be used or a requirement to follow specific operating instructions. Illustration 5 Right to direct the use of an asset Customer X enters into a contract with Supplier Y to use a vehicle for a three-year period. The vehicle is identified in the contract. Supplier Y cannot substitute another vehicle unless the specified vehicle is not operational (e.g., it breaks down). Under the contract: Customer X operates the vehicle (i.e., drives the vehicle) or directs others to operate the vehicle (e.g., hires a driver). Customer X decides how to use the vehicle (within contractual limitations, discussed below). For example, throughout the period of use, Customer X decides where the vehicle goes as well as when or whether it is used and what it is used for. Customer X can also change these decisions throughout the period of use. Supplier Y prohibits certain uses of the vehicle (e.g., moving it overseas) and modifications of the vehicle to protect its interest in the asset. Analysis: Customer X has the right to direct the use of the identified vehicle throughout the period of use. Customer X has the right to direct the use of the vehicle because it has the right to change how the vehicle is used, when or whether the vehicle is used, where the vehicle goes and what the vehicle is used for. Supplier Y s limits on certain uses for the vehicle and modifications to it are considered protective rights that define the scope of Customer X s use of the asset but do not affect the assessment of whether Customer X directs the use of the asset. 18 Technical Line A closer look at the new leases standard 31 March 2016

19 1.2.3 Examples The following flowchart is included in ASC 842 s implementation guidance and depicts the decision-making process for determining whether an arrangement is or contains a lease. Start Is there an identified asset? Consider paragraphs through (refer to section 1.2.1, Identified asset) No Yes Does the customer have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use? Consider paragraphs through (refer to section , Right to obtain substantially all of the economic benefits from the use of the identified asset ) No Customer Yes Does the customer or the supplier have the right to direct how and for what purpose the identified asset is used throughout the period of use? Consider paragraphs (a) and through (refer to section , Right to direct the use of the identified asset) Supplier An entity reassesses whether a contract contains a lease only if the terms and conditions of the contract are changed. Yes Neither; how and for what purpose the asset will be used is predetermined (refer to section , Right to direct the use of the identified asset) Does the customer have the right to operate the asset throughout the period of use without the supplier having the right to change those operating instructions? (refer to section , Right to direct the use of the identified asset) Did the customer design the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use? (refer to section , Right to direct the use of the identified asset) No Yes No The contract contains a lease The contract does not contain a lease Refer to Appendix A, Illustrations from ASC 842 on the application of the definition of a lease, for comprehensive illustrations from ASC 842 of the application of the definition of a lease. 1.3 Reassessment of the contract Leases Overall Scope and Scope Exceptions An entity shall reassess whether a contract is or contains a lease only if the terms and conditions of the contract are changed. 19 Technical Line A closer look at the new leases standard 31 March 2016

20 Under ASC 842, an entity reassesses whether a contract is or contains a lease only if the terms and conditions of the contract are changed. A change in the terms and conditions of a contract does not include the exercise of an option (e.g., renewal option) or failure to exercise an option that is included in the contract. 1.4 Identifying and separating lease and non-lease components of a contract and allocating contract consideration Identifying and separating lease components of a contract Leases Overall Scope and Scope Exceptions After determining that a contract contains a lease in accordance with paragraphs through 15-27, an entity shall identify the separate lease components within the contract. An entity shall consider the right to use an underlying asset to be a separate lease component (that is, separate from any other lease components of the contract) if both of the following criteria are met: a. The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee. Readily available resources are goods or services that are sold or leased separately (by the lessor or other suppliers) or resources that the lessee already has obtained (from the lessor or from other transactions or events). b. The right of use is neither highly dependent on nor highly interrelated with the other right(s) to use underlying assets in the contract. A lessee s right to use an underlying asset is highly dependent on or highly interrelated with another right to use an underlying asset if each right of use significantly affects the other The guidance in paragraph notwithstanding, to classify and account for a lease of land and other assets, an entity shall account for the right to use land as a separate lease component unless the accounting effect of doing so would be insignificant (for example, separating the land element would have no effect on lease classification of any lease component or the amount recognized for the land lease component would be insignificant). For contracts that contain the rights to use multiple assets but not land (e.g., a building and equipment, multiple pieces of equipment), the right to use each asset is considered a separate lease component if both of the following criteria are met: The lessee can benefit from the right of use either on its own or together with other resources that are readily available to the lessee (i.e., goods or services that are sold or leased separately, by the lessor or other suppliers, or that the lessee has already obtained from the lessor or in other transactions or events). The right of use is neither highly dependent on, nor highly interrelated with, the other right(s) to use the underlying assets in the contract. If one or both of these criteria are not met, the right to use multiple assets is considered a single lease component. For contracts that involve the right to use land and other assets (e.g., land and a building), ASC 842 requires an entity to classify (refer to chapter 3, Lease classification) and account for the right to use land as a separate lease component, even if the criteria above for separating lease components are not met, unless the accounting effect of not separately 20 Technical Line A closer look at the new leases standard 31 March 2016

21 accounting for the land is insignificant. The FASB indicated in the Basis for Conclusions (BC 147) that since land, by virtue of its indefinite economic life, is substantively different from other assets, it should be assessed separately regardless of whether the separate lease component criteria are met. How we see it An entity that leases an entire building (i.e., 100% of the building) is inherently leasing the land underneath the building and would potentially account for the land and the building as separate lease components. However, this would not necessarily be the case when an entity only leases part of the building (e.g., one floor of a multistory building). ASC 842 includes the following example for separating lease components of a contract (refer to section 1.4.5, Examples identifying and separating components of a contract and determining and allocating the consideration in the contract, for additional examples). Leases Overall Implementation Guidance and Illustrations Example 13 Lease of a Turbine Plant Lessor leases a gas-fired turbine plant to Lessee for eight years so that Lessee can produce electricity for its customers. The plant consists of the turbine housed within a building together with the land on which the building sits. The building was designed specifically to house the turbine, has a similar economic life as the turbine of approximately 15 years, and has no alternative use. The lease does not transfer ownership of any of the underlying assets to Lessee or grant Lessee an option to purchase any of the underlying assets. Lessor does not obtain a residual value guarantee from Lessee or any other unrelated third party. The present value of the lease payments is not substantially all of the aggregate fair value of the three underlying assets While the lease of the plant includes the lease of multiple underlying assets, the leases of those underlying assets do not meet the second criterion necessary to be separate lease components, which is that the right to use the underlying asset is neither dependent on nor highly interrelated with the other rights of use in the contract. Therefore, the contract contains only one lease component. The rights to use the turbine, the building, and the land are highly interrelated because each is an input to the customized combined item for which Lessee has contracted (that is, the right to use a gas-fired turbine plant that can produce electricity for distribution to Lessee s customers) However, because the contract contains the lease of land, Lessee and Lessor also must consider the guidance in paragraph Lessee and Lessor each conclude that the effect of accounting for the right to use the land as a separate lease component would be insignificant because Lessee s right to use the turbine, the building, and the land is coterminous and separating the right to use the land from the right to use the turbine and the building would not affect the lease classification of the turbine/building lease component. Lessee and Lessor each conclude that a single lease component comprising the turbine, the building, and the land would be classified as an operating lease, as would two separate lease components comprising the land and the turbine/building, respectively. 21 Technical Line A closer look at the new leases standard 31 March 2016

22 1.4.2 Identifying and separating lease from non-lease components of a contract Leases Overall Scope and Scope Exceptions The consideration in the contract shall be allocated to each separate lease component and nonlease component of the contract (see paragraphs through for lessee allocation guidance and paragraphs through for lessor allocation guidance). Components of a contract include only those items or activities that transfer a good or service to the lessee. Consequently, the following are not components of a contract and do not receive an allocation of the consideration in the contract: a. Administrative tasks to set up a contract or initiate the lease that do not transfer a good or service to the lessee b. Reimbursement or payment of the lessor s costs. For example, a lessor may incur various costs in its role as a lessor or as owner of the underlying asset. A requirement for the lessee to pay those costs, whether directly to a third party or as a reimbursement to the lessor, does not transfer a good or service to the lessee separate from the right to use the underlying asset An entity shall account for each separate lease component separately from the nonlease components of the contract (that is, unless a lessee makes the accounting policy election described in paragraph ). Nonlease components are not within the scope of this Topic and shall be accounted for in accordance with other Topics. Many contracts contain a lease coupled with an agreement to purchase or sell other goods or services (non-lease components). The non-lease components are identified and accounted for separately from the lease component in accordance with other US GAAP (except when a lessee applies the practical expedient as discussed in section , Practical expedient lessees). For example, the non-lease components may be accounted for as executory arrangements by lessees (customers) or as contracts subject to ASC 606, Revenue from Contracts with Customers, by lessors (suppliers). Some contracts contain items that do not relate to the transfer of goods or services by the lessor to the lessee (e.g., fees or other administrative costs that a lessor charges a lessee). These items should not be considered separate lease or non-lease components, and lessees and lessors do not allocate consideration in the contract to these items. Refer to section , Allocating the consideration in the contract, on lessee allocation of consideration in the contract and , Allocating the consideration in the contract, on lessor allocation of consideration in the contract. However, if the lessor provides services (e.g., maintenance including common area maintenance, supply of utilities) or operates the underlying asset (e.g., vessel charter, aircraft wet lease), the contract would generally contain non-lease components. 22 Technical Line A closer look at the new leases standard 31 March 2016

23 How we see it Identifying non-lease components of contracts may change practice for some lessees. Today, entities may not focus on identifying lease and non-lease components because their accounting treatment (e.g., the accounting for an operating lease and a service contract) is often the same. However, because most leases are recognized on lessees balance sheets under ASC 842, lessees may need to put more robust processes in place to identify the lease and non-lease components of contracts Executory costs Under ASC 840, lease-related executory costs (e.g., insurance, maintenance, taxes) are considered part of the lease component (or lease element) when lease and non-lease elements are separated. Under ASC 842, payments for maintenance activities, including common area maintenance (e.g., cleaning a lobby of a building, removing snow from a parking lot for employees and customers), are considered non-lease components. In some leases, a lessee also may reimburse the lessor, or make certain payments on behalf of the lessor, that relate to the leased asset such as payments for insuring the lessor s asset and real estate taxes associated with such asset. Under ASC 842, insurance that protects the lessor s interest in the underlying asset and taxes related to such asset (e.g., real estate taxes on the underlying asset) are not separate components of the contract because they do not represent payments for goods or services (i.e., the payments are for the use of the leased asset and are attributable to the lease component). Entities should also evaluate whether lease payments made for insurance that protects the lessor s interest in the underlying asset and taxes relating to such asset are fixed (or in-substance fixed) lease payments or variable lease payments. Refer to section 2.4, Lease payments. ASC 842 provides the following examples of accounting for lease-related executory costs. Leases Overall Implementation Guidance and Illustrations Example 12 Activities or Costs That Are Not Components of a Contract Case A Payments for Taxes and Insurance are Variable Lessor and Lessee enter into a five-year lease of a building. The contract designates that Lessee is required to pay for the costs relating to the asset, including the real estate taxes and the insurance on the building. The real estate taxes would be owed by Lessor regardless of whether it leased the building and who the lessee is. Lessor is the named insured on the building insurance policy (that is, the insurance protects Lessor s investment in the building, and Lessor will receive the proceeds from any claim). The annual lease payments are fixed at $10,000 per year, while the annual real estate taxes and insurance premium will vary and be billed to Lessee each year The real estate taxes and the building insurance are not components of the contract. The contract includes a single lease component the right to use the building. Lessee s payments of those amounts solely represent a reimbursement of Lessor s costs and do not represent payments for goods or services in addition to the right to use the building. However, because the real estate taxes and insurance premiums during the lease term are variable, those payments are variable lease payments that do not depend on an index or a rate and are excluded from the measurement of the lease liability and recognized in profit or loss in accordance with paragraph or Technical Line A closer look at the new leases standard 31 March 2016

24 Case B Payment for Taxes and Insurance are Fixed Assume the same facts and circumstances as in Case A (paragraphs through ), except that the fixed annual lease payment is $13,000. There are no additional payments for real estate taxes or building insurance; however, the fixed payment is itemized in the contract (that is, $10,000 for rent, $2,000 for real estate taxes, and $1,000 for building insurance). Consistent with Case A, the taxes and insurance are not components of the contract. The contract includes a single lease component, the right to use the building. The $65,000 in payments Lessee will make over the 5-year lease term are all lease payments for the single component of the contract and, therefore, are included in the measurement of the lease liability. Case C Common Area Maintenance Lessees can make a policy election to not separate a lease component from its associated non-lease components Assume the same facts and circumstances as in Case B (paragraph ), except that the lease is of space within the building, rather than for the entire building, and the fixed annual lease payment of $13,000 also covers Lessor s performance of common area maintenance activities (for example, cleaning of common areas, parking lot maintenance, and providing utilities to the building). Consistent with Case B, the taxes and insurance are not components of the contract. However, the common area maintenance is a component because Lessor s activities transfer services to Lessee. That is, Lessee receives a service from Lessor in the form of the common area maintenance activities it would otherwise have to undertake itself or pay another party to provide (for example, cleaning the lobby for its customers, removing snow from the parking lot for its employees and customers, and providing utilities). The common area maintenance is a single component in this contract rather than multiple components, because Lessor performs the activities as needed (for example, plows snow or undertakes minor repairs when and as necessary) over the same period of time Therefore, the contract in Case C includes two components a lease component (that is, the right to use the building) and a nonlease component. The consideration in the contract of $65,000 is allocated between those 2 components; the amount allocated to the lease component is the lease payments in accounting for the lease Practical expedient lessees Leases Overall Scope and Scope Exceptions As a practical expedient, a lessee may, as an accounting policy election by class of underlying asset, choose not to separate nonlease components from lease components and instead to account for each separate lease component and the nonlease components associated with that lease component as a single lease component. ASC 842 provides a practical expedient that permits lessees to make an accounting policy election (by class of underlying asset) to account for each separate lease component of a contract and its associated non-lease components as a single lease component. ASC 842 provides this expedient to alleviate concerns that the costs and administrative burden of 24 Technical Line A closer look at the new leases standard 31 March 2016

25 allocating consideration to separate lease and non-lease components may not be justified by the benefit of more precisely reflecting the right-of-use asset and the lease liability. Furthermore, the FASB expects the practical expedient to most often be used when the non-lease components of a contract are not significant when compared with the lease components of a contract. The practical expedient does not allow lessees to account for multiple lease components of a contract (refer to section 1.4.1, Identifying and separating lease components of a contract) as a single lease component. Refer to chapter 4, Lessee accounting, for a discussion of measurement of right-of-use assets and lease liabilities. Lessees that make the policy election to account for each separate lease component of a contract and its associated non-lease components as a single lease component allocate all of the contract consideration to the lease component. Therefore, the initial and subsequent measurement of the lease liability and right-of-use asset is higher than if the policy election was not applied Determining, allocating and reassessing the consideration in the contract lessees Determining the consideration in the contract Master Glossary Consideration in the Contract See paragraph for what constitutes the consideration in the contract for lessees and paragraph for what constitutes consideration in the contract for lessors. Leases Overall Scope and Scope Exceptions The consideration in the contract for a lessee includes all of the payments described in paragraph , as well as all of the following payments that will be made during the lease term: a. Any fixed payments (for example, monthly service charges) or in substance fixed payments, less any incentives paid or payable to the lessee, other than those included in paragraph b. Any other variable payments that depend on an index or a rate, initially measured using the index or rate at the commencement date. The consideration in the contract for a lessee includes all of the payments described as lease payments in section 2.4, Lease payments, as well as any of the following payments made during the lease term: Any fixed payments (e.g., monthly service charges) or in-substance fixed payments, less any incentives paid or payable to the lessee, other than those included in lease payments Any variable payments that depend on an index or a rate, initially measured using the index or rate at the commencement date (refer to section 2.2, Commencement date of the lease) 25 Technical Line A closer look at the new leases standard 31 March 2016

26 Allocating the consideration in the contract Master Glossary Standalone Price The price at which a customer would purchase a component of a contract separately. Leases Overall Scope and Scope Exceptions A lessee shall allocate (that is, unless the lessee makes the accounting policy election described in paragraph ) the consideration in the contract to the separate lease components determined in accordance with paragraphs through and the nonlease components as follows: a. The lessee shall determine the relative standalone price of the separate lease components and the nonlease components on the basis of their observable standalone prices. If observable standalone prices are not readily available, the lessee shall estimate the standalone prices, maximizing the use of observable information. A residual estimation approach may be appropriate if the standalone price for a component is highly variable or uncertain. b. The lessee shall allocate the consideration in the contract on a relative standalone price basis to the separate lease components and the nonlease components of the contract. Initial direct costs should be allocated to the separate lease components on the same basis as the lease payments A price is observable if it is the price that either the lessor or similar suppliers sell similar lease or nonlease components on a standalone basis. Lessees that do not make an accounting policy election (by class of underlying asset) to use the practical expedient (refer to section , Practical expedient lessees) to account for each separate lease component of a contract and its associated non-lease components as a single lease component are required to allocate the consideration in the contract to the lease and non-lease components on a relative standalone price basis. Lessees are required to use observable standalone prices (i.e., prices at which a customer would purchase a component of a contract separately) when readily available. If observable standalone prices are not readily available, lessees estimate standalone prices, maximizing the use of observable information. A residual estimation approach may be appropriate when the standalone price for a component is highly variable or uncertain. For contracts that contain multiple lease components (refer to section 1.4.1, Identifying and separating leases components of a contract), lessees also allocate initial direct costs (refer to section 2.6, Initial direct costs) to the separate lease components on the same basis as the lease payments. 26 Technical Line A closer look at the new leases standard 31 March 2016

27 Reassessment determining and allocating the consideration in the contract Leases Overall Scope and Scope Exceptions A lessee shall remeasure and reallocate the consideration in the contract upon either of the following: a. A remeasurement of the lease liability (for example, a remeasurement resulting from a change in the lease term or a change in the assessment of whether a lessee is or is not reasonably certain to exercise an option to purchase the underlying asset) (see paragraph ) b. The effective date of a contract modification that is not accounted for as a separate contract (see paragraph ). Lessees are required to remeasure and reallocate the consideration in a contract when they remeasure the lease liability, which occurs as a result of any of the following: A change to the lease term (e.g., a change resulting from a lessee s determination that it is reasonably certain to exercise an existing option to extend a lease that it had previously determined it was not reasonably certain to exercise) A change in the assessment of whether a lessee is reasonably certain to exercise an option to purchase the underlying asset A change in the amount that it is probable the lessee will owe under a residual value guarantee A resolution of a contingency that results in some or all of the lease payments that were previously determined to be variable meeting the definition of lease payments (e.g., an event occurs that results in variable lease payments that were linked to the performance or use of the underlying asset becoming fixed payments for the remainder of the lease term) Refer to section 4.4, Remeasurement of lease liabilities and right-of-use assets, for further discussion. Lessees are also required to remeasure and reallocate the consideration in the contract on the effective date of a contract modification (i.e., the date the lessor and lessee approve a change to the terms and conditions of the lease that results in a change in the scope of or the consideration for the lease) if the modified contract is not accounted for as a separate contract. Refer to section 4.5, Lease modifications. Also refer to Appendix B, Summary of lease reassessment and remeasurement requirements Determining, allocating and reassessing the consideration in the contract lessors Master Glossary Consideration in the Contract See paragraph for what constitutes the consideration in the contract for lessees and paragraph for what constitutes consideration in the contract for lessors. 27 Technical Line A closer look at the new leases standard 31 March 2016

28 Leases Overall Scope and Scope Exceptions A lessor shall allocate the consideration in the contract to the separate lease components and the nonlease components using the requirements in paragraphs through A lessor also shall allocate any capitalized costs (for example, initial direct costs or contract costs capitalized in accordance with Subtopic on other assets and deferred costs contracts with customers) to the separate lease components or nonlease components to which those costs relate The consideration in the contract for a lessor includes all of the amounts described in paragraph and any other variable payment amounts that would be included in the transaction price in accordance with the guidance on variable consideration in Topic 606 on revenue from contracts with customers that specifically relates to either of the following: a. The lessor s efforts to transfer one or more goods or services that are not leases b. An outcome from transferring one or more goods or services that are not leases. Any variable payment amounts accounted for as consideration in the contract shall be allocated entirely to the nonlease component(s) to which the variable payment specifically relates if doing so would be consistent with the transaction price allocation objective in paragraph If the terms of a variable payment amount other than those in paragraph relate to a lease component, even partially, the lessor shall recognize those payments as income in profit or loss in the period when the changes in facts and circumstances on which the variable payment is based occur (for example, when the lessee s sales on which the amount of the variable payment depends occur) Determining the consideration in the contract The consideration in the contract for a lessor includes all of the following: The payments described as lease payments in section 2.4, Lease payments Any other fixed payments (e.g., monthly service charges) or in-substance fixed payments made during the lease term, less any incentives paid or payable to the lessee Any other variable payments that depend on an index or a rate made during the lease term and initially measured using the index or rate at the commencement date (refer to section 2.2, Commencement date of the lease) Any other variable payment amounts that would be included in the transaction price in accordance with the guidance on variable consideration in ASC 606 that specifically relate to either of the following: The lessor s efforts to transfer one or more goods or services that are not leases An outcome from transferring one or more goods or services that are not leases 28 Technical Line A closer look at the new leases standard 31 March 2016

29 Variable consideration is defined broadly in ASC 606 and can take many forms. Consideration can vary because of discounts, rebates, refunds, credits, price concessions, incentives, performance bonuses, penalties or other similar items. It is important for lessors to appropriately identify the different types of variable consideration included in the contract because estimating variable consideration requires lessors to apply a constraint to each type of variable consideration. Refer to section 5.1, Variable consideration, of our Financial reporting developments publication, Revenue from contracts with customers (ASC 606), for an in-depth discussion of the forms of variable consideration, estimating variable consideration and constraining estimates of variable consideration Allocating the consideration in the contract When applying ASC 842, lessors are required to apply ASC to to allocate the consideration in the contract between the lease and non-lease components on a relative standalone selling price basis. The standalone selling price is the price at which an entity would sell a promised good or service separately to a customer. When standalone selling prices are not directly observable, the lessor must estimate the standalone selling price. The guidance in ASC provides suitable methods for estimating the standalone selling price. Lessors allocate the consideration in the contract between the lease and non-lease components of the contract on a relative standalone selling price basis. The requirement to estimate a standalone selling price is not a new concept for lessors that apply the multiple-element arrangements guidance in ASC , Multiple-Element Arrangements, to leases accounted for under ASC 840. The guidance on estimating a standalone selling price in ASC 606 is generally consistent with ASC except that it doesn t require an entity to consider a hierarchy of evidence to make this estimate. A lessor allocates any variable payment amounts accounted for as consideration in the contract entirely to the non-lease component(s) to which the variable payment specifically relates if doing so would be consistent with the transaction price allocation objective in ASC If any part of the variable payment amounts relate to the lease component, even partially, a lessor treats the entire variable payment as a variable lease payment. That is, a lessor recognizes the variable lease payments as income in the period when the changes in facts and circumstances on which the variable payment is based occur. That income is allocated, on the same basis as the initial allocation of consideration in the contract, between lease and non-lease components when recognized. Refer to section 6.1, Estimating standalone selling prices, of our Financial reporting developments publication, Revenue from contracts with customers (ASC 606), for an in-depth discussion of estimating the standalone selling price and the possible estimation methods. How we see it We anticipate that personnel responsible for an entity s revenue recognition policies (including revenue recognition policies associated with arrangements that include a lease) will need to obtain information from personnel beyond those in the accounting or finance departments to estimate standalone selling prices. That is, we expect them to need to gain information and an understanding of an entity s pricing decisions in order to determine estimated standalone selling prices, especially when there are limited or no observable inputs. This may be a change for some entities that do not today estimate standalone selling prices. 4 The objective when allocating the transaction price is for an entity to allocate the transaction price to each performance obligation (or distinct good or service) in an amount that depicts the amount of consideration to which the entity expects to be entitled in exchange for transferring the promised goods or services to the customer. 29 Technical Line A closer look at the new leases standard 31 March 2016

30 Reassessment determining and allocating the consideration in the contract Leases Overall Scope and Scope Exceptions A lessor shall remeasure and reallocate the remaining consideration in the contract when there is a contract modification that is not accounted for as a separate contract in accordance with paragraph If the consideration in the contract changes, a lessor shall allocate those changes in accordance with the requirements in paragraphs through Lessors will remeasure and reallocate the remaining consideration in the contract upon a contract modification (i.e., a change to the terms and conditions of the contract that results in a change in the scope of or the consideration for the lease) that is not accounted for as a separate contract. Refer to section 5.6, Lease modifications. In addition, lessors will apply ASC 606 to allocate changes in the consideration in the contract. For example, the consideration in the contract changes if a lessor concludes in applying ASC 606 that there is a change in the amount it will receive for variable payments related to services that are not leases. Refer to section 6.5, Changes in transaction price after contract inception, of our Financial reporting developments publication, Revenue from contracts with customers (ASC 606), for a discussion of changes in transaction prices after contract inception. Refer to Appendix B, Summary of lease reassessment and remeasurement requirements Examples identifying and separating components of a contract and determining and allocating the consideration in the contract ASC 842 provides the following examples to illustrate how lessees and lessors identify and separate lease and non-lease components of a contract and determine and allocate the consideration in the contract. Leases Overall Implementations Guidance and Illustrations Example 11 Allocation of Consideration to Lease and Nonlease Components of a Contract Case A Allocation of Consideration in the Contract Lessor leases a bulldozer, a truck, and a crane to Lessee to be used in Lessee s construction operations for three years. Lessor also agrees to maintain each piece of equipment throughout the lease term. The total consideration in the contract is $600,000, payable in $200,000 annual installments Lessee and Lessor both conclude that the leases of the bulldozer, the truck, and the crane are each separate lease components because both of the criteria in paragraph are met. That is: a. The criterion in paragraph (a) is met because Lessee can benefit from each of the three pieces of equipment on its own or together with other readily available resources (for example, Lessee could readily lease or purchase an alternative truck or crane to use with the bulldozer). 30 Technical Line A closer look at the new leases standard 31 March 2016

31 b. The criterion in paragraph (b) is met because, despite the fact that Lessee is leasing all three machines for one purpose (that is, to engage in construction operations), the machines are not highly dependent on or highly interrelated with each other. The machines are not, in effect, inputs to a combined single item for which Lessee is contracting. Lessor can fulfill each of its obligations to lease one of the underlying assets independently of its fulfillment of the other lease obligations, and Lessee s ability to derive benefit from the lease of each piece of equipment is not significantly affected by its decision to lease or not lease the other equipment from Lessor In accordance with paragraph , Lessee and Lessor will account for the nonlease maintenance services components separate from the three separate lease components (unless Lessee elects the practical expedient see Case B [paragraphs through ]). In accordance with the identifying performance obligations guidance in paragraphs through 25-22, Lessor further concludes that its maintenance services for each piece of leased equipment are distinct and therefore separate performance obligations, resulting in the conclusion that there are three separate lease components and three separate nonlease components (that is, three maintenance service performance obligations) Lessor allocates the consideration in the contract to the separate lease components and nonlease components by applying the guidance in paragraphs through The consideration allocated to each separate lease component constitutes the lease payments for purposes of Lessor s accounting for those components Lessee allocates the consideration in the contract to the separate lease and nonlease components. Several suppliers provide maintenance services that relate to similar equipment such that there are observable standalone prices for the maintenance services for each piece of leased equipment. In addition, even though Lessor, who is the manufacturer of the equipment, requires that all leases of its equipment include maintenance services, Lessee is able to establish observable standalone prices for the three lease components on the basis of the price other lessors lease similar equipment on a standalone basis. The standalone prices for the separate lease and nonlease components are as follows. Lease Maintenance Bulldozer $ 200,000 $ 50,000 Truck $ 120,000 $ 20,000 Crane $ 240,000 $ 70,000 $ 560,000 $ 140, Lessee first allocates the consideration in the contract ($600,000) to the lease and nonlease components on a relative basis, utilizing the observable standalone prices determined in paragraph Lessee then accounts for each separate lease component in accordance with Subtopic , treating the allocated consideration as the lease payments for each lease component. The nonlease components are accounted for by Lessee in accordance with other Topics. The allocation of the consideration to the lease and nonlease components is as follows. Lease Maintenance Bulldozer $ 171,429 $ 42,857 Truck $ 102,857 $ 17,143 Crane $ 205,714 $ 60,000 $ 480,000 $ 120, Technical Line A closer look at the new leases standard 31 March 2016

32 The following example from ASC 842 assumes the same facts as Case A above except that the lessee has made an accounting policy election to use the practical expedient to not separate non-lease components from their associated lease components. Leases Overall Implementations Guidance and Illustrations Example 11 Allocation of Consideration to Lease and Nonlease Components of a Contract Case B Lessee Elects Practical Expedient to Not Separate Lease from Nonlease Components Assume the same facts and circumstances as in Case A (paragraphs through ), except that Lessee has made an accounting policy election to use the practical expedient to not separate nonlease from lease components for its leased construction equipment. Consequently, Lessee does not separate the maintenance services from the related lease components but, instead, accounts for the contract as containing only three lease components Because Lessor regularly leases each piece of equipment bundled together with maintenance services on a standalone basis, there are observable standalone prices for each of the three combined components, each of which includes the lease and the maintenance services. Because each of the three separate lease components includes the lease of the equipment and the related maintenance services, the observable standalone price for each component in this scenario is greater than the observable standalone price for each separate lease component that does not include the maintenance services in Case A Lessee allocates the consideration in the contract ($600,000) to the three separate lease components on a relative basis utilizing the observable standalone selling price of each separate lease component (inclusive of maintenance services) and then accounts for each separate lease component in accordance with the guidance in Subtopic , treating the allocated consideration as the lease payments for each separate lease component. The standalone prices for each of the three combined lease components is as follows. Relative Standalone Standalone Price Price Bulldozer $ 230,000 $ 215,625 Truck $ 130,000 $ 121,875 Crane $ 280,000 $ 262,500 $ 640,000 $ 600,000 ASC 842 provides the following examples to illustrate how lessees and lessors identify and separate lease and non-lease components of a contract and determine and allocate the consideration in the contract when there are variable payments that relate to the lease component and the non-lease component. 32 Technical Line A closer look at the new leases standard 31 March 2016

33 Leases Overall Implementations Guidance and Illustrations Example 14 Determining the Consideration in the Contract Variable Payments Case A Variable Payments That Relate to the Lease Component and the Nonlease Component Lessee and Lessor enter into a three-year lease of equipment that includes maintenance services on the equipment throughout the three-year lease term. Lessee will pay Lessor $100,000 per year plus an additional $7,000 each year that the equipment is operating a minimum number of hours at a specified level of productivity (that is, the equipment is not malfunctioning or inoperable). The potential $7,000 payment each year is variable because the payment depends on the equipment operating a minimum number of hours at a specified level of productivity. The lease is an operating lease In accordance with paragraph , variable payments other than those that depend on an index or a rate are not accounted for as consideration in the contract by Lessee. Therefore, the consideration in the contract to be allocated by Lessee to the equipment lease and the maintenance services at lease commencement includes only the fixed payments of $100,000 each year (or $300,000 in total). Lessee allocates the consideration in the contract to the equipment lease and the maintenance services on the basis of the standalone prices of each, which, for purposes of this example, are $285,000 and $45,000, respectively. Relative Standalone Standalone Price Price Lease $ 285,000 $ 259,091 Maintenance $ 45,000 $ 40,909 $ 330,000 $ 300,000 Each $100,000 annual fixed payment and each variable payment are allocated to the equipment lease and the maintenance services on the same basis as the initial allocation of the consideration in the contract (that is, 86.4 percent to the equipment lease and 13.6 percent to the maintenance services). Therefore, annual lease expense, excluding variable expense, is $86,364. Lessee recognizes the expense related to the variable payments in accordance with paragraphs and through In accordance with paragraphs through 15-40, Lessor also concludes that the potential variable payments should not be accounted for as consideration in the contract. That is because the potential variable payment each year is not solely related to performance of the nonlease maintenance services; the quality and condition of the underlying asset also substantively affect whether Lessor will earn those amounts. Therefore, Lessor s allocation of the consideration in the contract ($300,000) in this Example is the same as Lessee. Lessor, in the same manner as Lessee, also will recognize the income related to the variable payments and allocate that income between the lease and nonlease maintenance services (on the same basis as the initial allocation of the consideration in the contract), when and if earned. 33 Technical Line A closer look at the new leases standard 31 March 2016

34 The following example assumes the same facts as Case A above except that the variable payments relate specifically to a non-lease component. Leases Overall Implementations Guidance and Illustrations Example 14 Determining the Consideration in the Contract Variable Payments Case B Variable Payments That Relate Specifically to a Nonlease Component Assume the same facts and circumstances as in Case A (paragraphs through ), except in this scenario the maintenance services are highly specialized and no entity would expect the equipment to meet the performance metrics without the specialized maintenance services Lessee would account for the potential variable payments consistent with Case A. The rationale for this accounting also is consistent with that in Case A In contrast to Case A, Lessor concludes that the variable payments relate specifically to an outcome from Lessor s performance of its maintenance services. Therefore, Lessor evaluates the variable payments in accordance with the variable consideration guidance in paragraphs through If Lessor estimates, using the most likely amount method, that it will be entitled to receive the $21,000 in variable payments and that it is probable that including that amount in the transaction price for the maintenance services would not result in a significant revenue reversal when the uncertainty of the performance bonus is resolved, the $21,000 would be included in the consideration in the contract. Because allocating the $21,000 entirely to the maintenance services would not result in an allocation that is consistent with the allocation objective in paragraph (that is, it would result in allocating $61,909 to the maintenance services and the remainder to the equipment lease, which would not reasonably depict the consideration to which Lessor expects to be entitled for each component), the entire consideration in the contract of $321,000 is allocated on a relative standalone price basis as follows. Relative Standalone Standalone Price Price Lease $ 285,000 $ 277,227 Maintenance $ 45,000 $ 43,773 $ 330,000 $ 321, The $277,227 allocated to the equipment lease is the lease payment in accounting for the lease in accordance with Subtopic Lessor will recognize the consideration in the contract allocated to the maintenance services in accordance with the guidance on the satisfaction of performance obligations in paragraphs through If the consideration in the contract changes (for example, because Lessor no longer estimates that it will receive the full $21,000 in potential variable payments), Lessor will allocate the change in the transaction price on the same basis as was initially done. 34 Technical Line A closer look at the new leases standard 31 March 2016

35 The following example assumes the same facts as Case B above except that the variable payments relate specifically to a non-lease component. Leases Overall Implementations Guidance and Illustrations Example 14 Determining the Consideration in the Contract Variable Payments Case C Allocating Variable Payments Entirely to a Nonlease Component Assume the same facts and circumstances as in Case B (paragraphs through ), except that in this scenario all of the following apply: a. The potential variable payments are $14,000 per year ($42,000 in total), and the annual fixed payments are $93,000 per year ($279,000 in total). b. While Lessor s estimate of the variable payments to which it will be entitled is $42,000, Lessor concludes that it is not probable that including the full $42,000 in potential variable payments in the consideration in the contract will not result in a significant revenue reversal (that is, the entity applies the constraint on variable consideration in paragraph ). Lessor concludes that only $28,000 is probable of not resulting in a significant revenue reversal. Therefore, the consideration in the contract is initially $307,000 ($279,000 + $28,000) In contrast to Case B, Lessor concludes that allocating the variable payments entirely to the maintenance services and the fixed payments entirely to the equipment lease is consistent with the allocation objective in paragraph This is because $42,000 (Lessor considers its estimate of the variable payments to which it expects to be entitled exclusive of the constraint on variable consideration in Topic 606 on revenue recognition) and $279,000 approximate the standalone price of the maintenance services ($45,000) and the equipment lease ($285,000), respectively. Because the variable payments are allocated entirely to the maintenance services, if the consideration in the contract changes (for example, because Lessor concludes it is now probable that it will earn the full $42,000 in variable payments), that change is allocated entirely to the maintenance services component in the contract. 35 Technical Line A closer look at the new leases standard 31 March 2016

36 1.5 Contract combinations Leases Overall Recognition An entity shall combine two or more contracts, at least one of which is or contains a lease, entered into at or near the same time with the same counterparty (or related parties) and consider the contracts as a single transaction if any of the following criteria are met: a. The contracts are negotiated as a package with the same commercial objective(s). b. The amount of consideration to be paid in one contract depends on the price or performance of the other contract. c. The rights to use underlying assets conveyed in the contracts (or some of the rights of use conveyed in the contracts) are a single lease component in accordance with paragraph ASC 842 requires that two or more contracts entered into at or near the same time with the same counterparty (or related party) be considered a single contract if at least one of the contracts is or contains a lease and any one of the following criteria is met: The contracts are negotiated as a package with the same commercial objective(s). The amount of consideration to be paid in one contract depends on the price or performance of the other contract. The rights to use the underlying assets conveyed in the contracts (or some of the rights of use conveyed in the contracts) are a single lease component (refer to section 1.4.1, Identifying and separating lease components of a contract). The FASB indicated in the Basis for Conclusions (BC 165) that it developed these criteria to address concerns that separately accounting for multiple contracts may not result in a faithful representation of the combined transaction. 36 Technical Line A closer look at the new leases standard 31 March 2016

37 2 Key concepts Lessees and lessors generally apply the same key concepts for purposes of identifying, classifying, recognizing and measuring lease contracts. 2.1 Inception of a contract ASC requires customers and suppliers to determine whether a contract is or contains a lease at the inception of the contract. Entities should consider other US GAAP to determine how to account for and disclose the existence of rights or obligations created between the inception of a contract that is or contains a lease and the commencement date of the lease. 2.2 Commencement date of the lease Master Glossary Commencement Date of the Lease (Commencement Date) The date on which a lessor makes an underlying asset available for use by a lessee. See paragraphs through for implementation guidance on the commencement date. Entities determine whether a contract is or contains a lease at the inception of the contract. Underlying Asset An asset that is the subject of a lease for which a right to use that asset has been conveyed to a lessee. The underlying asset could be a physically distinct portion of a single asset. Leases Overall Implementation Guidance and Illustrations In some lease arrangements, the lessor may make the underlying asset available for use by the lessee (for example, the lessee may take possession of or be given control over the use of the underlying asset) before it begins operations or makes lease payments under the terms of the lease. During this period, the lessee has the right to use the underlying asset and does so for the purpose of constructing a lessee asset (for example, leasehold improvements) The contract may require the lessee to make lease payments only after construction is completed and the lessee begins operations. Alternatively, some contracts require the lessee to make lease payments when it takes possession of or is given control over the use of the underlying asset. The timing of when lease payments begin under the contract does not affect the commencement date of the lease Lease costs (or income) associated with building and ground leases incurred (earned) during and after a construction period are for the right to use the underlying asset during and after construction of a lessee asset. There is no distinction between the right to use an underlying asset during a construction period and the right to use that asset after the construction period. Therefore, lease costs (or income) associated with ground or building leases that are incurred (earned) during a construction period should be recognized by the lessee (or lessor) in accordance with the guidance in Subtopics and , respectively. That guidance does not address whether a lessee that accounts for the sale or rental of real estate projects under Topic 970 should capitalize rental costs associated with ground and building leases. 37 Technical Line A closer look at the new leases standard 31 March 2016

38 The commencement date is the date on which the lessor makes an underlying asset (i.e., the property, plant or equipment that is subject to the lease) available for use by the lessee. In some cases, the commencement date of the lease may be before the date stipulated in the lease agreement (e.g., the date rents become due and payable). This often occurs when the leased space is modified by the lessee prior to commencing operations in the leased space (e.g., during the period a lessee uses the leased space to construct its own leasehold improvements). If a lessee takes possession of, or is given control over, the use of the underlying asset before it begins operations or making lease payments under the terms of the lease, the lease term has commenced even if the lessee is not required to pay rent or the lease arrangement states the lease commencement date is a later date. As a result, the straight-line rent computation for operating leases must include the deemed rent holiday period (refer to section 4.2.2, Subsequent measurement, for a discussion of the subsequent measurement of an operating lease). The timing of when lease payments begin under the contract does not affect the commencement date of the lease. For example, a lessee (except lessees applying the short-term lease exception discussed in section 4.1.1, Short-term leases) initially recognizes a lease liability and related right-of-use asset on the commencement date and a lessor (for direct financing and most sales-type leases) initially recognizes its net investment in the lease on the commencement date. 2.3 Lease term and purchase options Lease term Master Glossary Lease Term The noncancellable period for which a lessee has the right to use an underlying asset, together with all of the following: a. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option b. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option c. Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor. Leases Overall Initial Measurement An entity shall determine the lease term as the noncancellable period of the lease, together with all of the following: a. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option b. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option c. Periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor. 38 Technical Line A closer look at the new leases standard 31 March 2016

39 At the commencement date, an entity shall include the periods described in paragraph in the lease term having considered all relevant factors that create an economic incentive for the lessee (that is, contract-based, asset-based, entity-based, and market-based factors). Those factors shall be considered together, and the existence of any one factor does not necessarily signify that a lessee is reasonably certain to exercise or not to exercise an option. Implementation Guidance and Illustrations The lease term begins at the commencement date and includes any rent-free periods provided to the lessee by the lessor. The lease term begins at the lease commencement date and is determined on that date based on the noncancellable term of the lease, together with all of the following: Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option Periods covered by an option to extend (or not terminate) the lease in which the exercise of the option is controlled by the lessor The FASB indicated in the Basis for Conclusions (BC 195) that the phrase reasonably certain, which is used in IAS 17 and is generally interpreted as a high threshold, has the same meaning as the phrase reasonably assured that is currently used in ASC 840. Therefore, the FASB does not anticipate a change in practice Purchase options Leases Overall Initial Measurement At the commencement date, an entity shall assess an option to purchase the underlying asset on the same basis as an option to extend or not to terminate a lease, as described in paragraph Purchase options should be assessed in the same way as options to extend the lease term or terminate the lease. The FASB indicated in the Basis for Conclusions (BC 218) that an option to purchase an underlying asset is economically similar to an option to extend the lease term for the remaining economic life of the underlying asset. When a lease contains a purchase option and the lessee is reasonably certain to exercise that option, the lease is classified as a finance lease by a lessee and a sales-type lease by a lessor. Refer to chapter 3, Lease classification. 39 Technical Line A closer look at the new leases standard 31 March 2016

40 2.3.3 Evaluating lease term and purchase options When evaluating whether a lessee is reasonably certain to exercise an option to renew the lease, not terminate the lease or to purchase the underlying asset, lessees and lessors are required to assess all relevant factors that create an economic incentive for the lessee to exercise lease renewal, termination or purchase options (i.e., contract-, asset-, entity- and market-based factors) including: The existence of a purchase option or lease renewal option and its pricing (e.g., fixed rates, discounted rates, bargain rates) The existence of a termination option, the amount of payments for termination or nonrenewal and the pricing of the continuing lease Contingent amounts due under residual value guarantees and other variable lease payments Costs of returning the asset in a contractually specified condition or to a contractually specified location Significant customization (e.g., leasehold improvements), installation costs or relocation costs The importance of the leased asset to the lessee s operations, considering the potential business disruptions from not having the leased asset and the availability of a replacement asset A sublease term that extends beyond the noncancellable period of the head lease (e.g., a head lease that has a noncancellable term of five years with a two-year renewal option, and the sublease term is for seven years) The longer the period from commencement of the lease (refer to section 2.2, Commencement date of the lease) to the exercise date of an option, the more difficult it will be, in certain cases, to determine whether the exercise of the option is reasonably certain. The difficulty arises from several factors. For example, a lessee s estimates of its future needs for the leased asset become less precise the further into the future the forecast goes. Also, the future fair value of certain assets such as those involving technology is more difficult to predict than the future fair value of a relatively stable asset, such as a fully leased commercial office building located in a prime area. The further into the future that the option date is, the lower the option price must be in relation to the estimated future fair value to conclude that the lessee is reasonably certain to exercise the option. The difference between the option price and the estimated future fair value of an asset that is subject to significant changes in value also should be greater than would be the case for an asset with a relatively stable value. An artificially short lease term (e.g., a lease of a corporate headquarters, distribution facility, manufacturing plant or other key property with a four-year lease term) may effectively create a significant economic incentive for the lessee to exercise a purchase or renewal option. This may be evidenced by the significance of the underlying asset to the lessee s continuing operations and whether, absent the option, the lessee would have entered into such a lease. Similarly, the significance of the underlying asset to the lessee s operations may create a significant economic disincentive that affects a lessee s decisions about whether it is reasonably certain to exercise a purchase or renewal option. For example, a company that leases a specialized facility (e.g., manufacturing plant, distribution facility, corporate headquarters) and doesn t exercise a purchase or renewal option would face a significant economic penalty if an alternative facility is not readily available. This would potentially have an adverse effect on the company while it searched for a replacement asset. 40 Technical Line A closer look at the new leases standard 31 March 2016

41 Illustration 6 Determining the lease term Scenario A Assume that Entity P enters into a lease for equipment that includes a noncancellable term of four years and a two-year fixed-priced renewal option with future lease payments that are intended to approximate market rates at lease inception. There are no termination penalties or other factors indicating that Entity P is reasonably certain to exercise the renewal option. Analysis: At the lease commencement date, the lease term is four years. Scenario B Assume that Entity Q enters into a lease for a building that includes a noncancellable term of four years and a two-year, fixed-priced renewal option with future lease payments that are intended to approximate market rates at lease inception. Before it takes possession of the building, Entity Q pays for leasehold improvements. The leasehold improvements are expected to have significant value at the end of four years, and that value can only be realized through continued occupancy of the leased property. Analysis: At lease commencement, Entity Q determines that it is reasonably certain to exercise the renewal option because it would suffer a significant economic penalty if it abandoned the leasehold improvements at the end of the initial noncancellable period. At lease commencement, Entity Q concludes that the lease term is six years Cancellable leases Master Glossary Penalty Any requirement that is imposed or can be imposed on the lessee by the lease agreement or by factors outside the lease agreement to do any of the following: a. Disburse cash b. Incur or assume a liability c. Perform services d. Surrender or transfer an asset or rights to an asset or otherwise forego an economic benefit, or suffer an economic detriment. Factors to consider in determining whether an economic detriment may be incurred include, but are not limited to, all of the following: 1. The uniqueness of purpose or location of the underlying asset 2. The availability of a comparable replacement asset 3. The relative importance or significance of the underlying asset to the continuation of the lessee's line of business or service to its customers 4. The existence of leasehold improvements or other assets whose value would be impaired by the lessee vacating or discontinuing use of the underlying asset 5. Adverse tax consequences 6. The ability or willingness of the lessee to bear the cost associated with relocation or replacement of the underlying asset at market rental rates or to tolerate other parties using the underlying asset. 41 Technical Line A closer look at the new leases standard 31 March 2016

42 Leases Overall Implementation Guidance and Illustrations An entity should determine the noncancellable period of a lease when determining the lease term. When assessing the length of the noncancellable period of a lease, an entity should apply the definition of a contract and determine the period for which the contract is enforceable. A lease is no longer enforceable when both the lessee and the lessor each have the right to terminate the lease without permission from the other party with no more than an insignificant penalty If only a lessee has the right to terminate a lease, that right is considered to be an option to terminate the lease available to the lessee that an entity considers when determining the lease term, as described in paragraph If only a lessor has the right to terminate a lease, the noncancellable period of the lease includes the period covered by the option to terminate the lease. ASC 842 applies to contracts that are referred to as cancellable, month-to-month, at will, evergreen, perpetual or rolling if they create enforceable rights and obligations. An arrangement is not enforceable if both the lessee and the lessor each have the right to terminate the lease without permission from the other party and with no more than an insignificant penalty. Any noncancellable periods (by the lessee and the lessor) in contracts that meet the definition of a lease are considered part of the lease term. If only a lessor has the right to terminate a lease, the period covered by the option to terminate the lease is included in the noncancellable period of the lease. If only a lessee has the right to terminate a lease, that right is a termination option that is considered when determining the lease term. Illustration 7 Cancellable leases A lease has an initial noncancellable period of one year and an extension for an additional year if both the lessee and the lessor agree. There is no penalty if the lessee and the lessor do not agree. The initial one-year noncancellable period meets the definition of a contract because it creates enforceable rights and obligations. However, the one-year extension period does not meet the definition of a contract because both the lessee and the lessor could unilaterally elect to not extend the arrangement without penalty Reassessment of the lease term and purchase options Lessees Leases Overall Subsequent Measurement A lessee shall reassess the lease term or a lessee option to purchase the underlying asset only if and at the point in time that any of the following occurs: a. There is a significant event or a significant change in circumstances that is within the control of the lessee that directly affects whether the lessee is reasonably certain to exercise or not to exercise an option to extend or terminate the lease or to purchase the underlying asset. b. There is an event that is written into the contract that obliges the lessee to exercise (or not to exercise) an option to extend or terminate the lease. 42 Technical Line A closer look at the new leases standard 31 March 2016

43 c. The lessee elects to exercise an option even though the entity had previously determined that the lessee was not reasonably certain to do so. d. The lessee elects not to exercise an option even though the entity had previously determined that the lessee was reasonably certain to do so. Implementation Guidance and Illustrations Examples of significant events or significant changes in circumstances that a lessee should consider in accordance with paragraph include, but are not limited to, the following: a. Constructing significant leasehold improvements that are expected to have significant economic value for the lessee when the option becomes exercisable b. Making significant modifications or customizations to the underlying asset c. Making a business decision that is directly relevant to the lessee s ability to exercise or not to exercise an option (for example, extending the lease of a complementary asset or disposing of an alternative asset) d. Subleasing the underlying asset for a period beyond the exercise date of the option A change in market-based factors (such as market rates to lease or purchase a comparable asset) should not, in isolation, trigger reassessment of the lease term or a lessee option to purchase the underlying asset. After lease commencement (refer to section 2.2, Commencement date of the lease), ASC 842 requires lessees to monitor leases for significant changes that could trigger a change in the lease term. Lessees are required to reassess the lease term (i.e., the likelihood of exercising a renewal or termination option) or whether it is reasonably certain that they will exercise an option to purchase the underlying asset at the point in time when any of the following occurs: There is a significant event or significant change in circumstances within the lessee s control that directly affects whether the lessee is reasonably certain to (1) extend the lease, (2) not terminate the lease or (3) purchase the underlying asset. There is an event that is written into the contract that obliges the lessee to exercise or not to exercise an option to extend or terminate the lease. The lessee elects to exercise an option even though it had previously determined that it was not reasonably certain to do so. The lessee elects not to exercise an option even though it had previously determined that it was reasonably certain to do so. Examples of significant events or significant changes in circumstances within the lessee s control include: Constructing significant leasehold improvements that are expected to have significant economic value for the lessee when the option becomes exercisable Making significant modifications or customizations to the underlying asset Making a business decision that is directly relevant to the lessee s ability to exercise or not exercise an option (e.g., extending the lease of a complementary asset or disposing of an alternative asset) Subleasing the underlying asset for a period beyond the exercise date of the option 43 Technical Line A closer look at the new leases standard 31 March 2016

44 Changes in market-based factors (e.g., a change in market rates to lease or purchase a comparable asset) are not within the lessee s control, and they therefore don t trigger a reassessment by themselves. ASC requires a lessee to reassess lease classification when there is a change in its assessment of either the lease term or whether it is reasonably certain to exercise an option to purchase the underlying asset. Refer to section 3.6, Reassessment of lease classification. Additionally, if there is a change in a lessee s assessment of either the lease term or whether it is reasonably certain to exercise an option to purchase the underlying asset, a lessee should remeasure the lease liability, using revised inputs (e.g., discount rate see section 2.5, Discount rates; allocation of contract consideration see section , Allocating the consideration in the contract) at the reassessment date, and adjust the right-of-use asset. However, if the right-of-use asset is reduced to zero, a lessee would recognize any remaining amount in profit or loss. Refer to chapter 4, Lessee accounting. Refer to Appendix B, Summary of lease reassessment and remeasurement requirements Lessors Leases Overall Subsequent Measurement A lessor shall not reassess the lease term or a lessee option to purchase the underlying asset unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph When a lessee exercises an option to extend or terminate the lease or purchase the underlying asset, the lessor shall account for the exercise of that option in the same manner as a lease modification. A lessor does not reassess the lease term or a lessee s option to purchase the underlying asset after lease commencement unless the lease is modified (i.e., the terms and conditions of the contract are changed in a way that results in a change in the scope of or the consideration for the lease) and the modified lease is not accounted for as a separate contract. Additionally, ASC requires a lessor to account for a lessee s exercise of an option to extend or terminate the lease or purchase the underlying asset in the same manner as a lease modification. Refer to section 5.6, Lease modifications. How we see it We believe that the exercise of an option to extend or terminate the lease or purchase the underlying asset should be accounted for in the same manner as a lease modification only when the exercise of the option is inconsistent with the lessor s assumption about whether the lessee will exercise the option. For example, if a lessor included an optional period to extend the lease in the lease term because it concluded that the lessee is reasonably certain to exercise that option, we do not believe that the exercise of the option should be accounted for as a lease modification. Refer to Appendix B, Summary of lease reassessment and remeasurement requirements. 44 Technical Line A closer look at the new leases standard 31 March 2016

45 2.4 Lease payments Master Glossary Lease Payments See paragraph for what constitutes lease payments from the perspective of a lessee and a lessor. Variable Lease Payments Payments made by a lessee to a lessor for the right to use an underlying asset that vary because of changes in facts or circumstances occurring after the commencement date, other than the passage of time. Probable (second definition) The future event or events are likely to occur. Residual Value Guarantee A guarantee made to a lessor that the value of an underlying asset returned to the lessor at the end of a lease will be at least a specified amount. Leases Overall Initial Measurement At the commencement date, the lease payments shall consist of the following payments relating to the use of the underlying asset during the lease term: a. Fixed payments, including in substance fixed payments, less any lease incentives paid or payable to the lessee (see paragraphs through 55-31). b. Variable lease payments that depend on an index or a rate (such as the Consumer Price Index or a market interest rate), initially measured using the index or rate at the commencement date. c. The exercise price of an option to purchase the underlying asset if the lessee is reasonably certain to exercise that option (assessed considering the factors in paragraph ). d. Payments for penalties for terminating the lease if the lease term (as determined in accordance with paragraph ) reflects the lessee exercising an option to terminate the lease. e. Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction. However, such fees shall not be included in the fair value of the underlying asset for purposes of applying paragraph (d). f. For a lessee only, amounts probable of being owed by the lessee under residual value guarantees (see paragraphs through 55-36). 45 Technical Line A closer look at the new leases standard 31 March 2016

46 Lease payments are payments, made by a lessee to a lessor, relating to the right to use an underlying asset during the lease term and include the following amounts: Fixed (including in-substance fixed) payments, less any lease incentives paid or payable to the lessee (refer to section 2.4.1, Fixed (including in-substance fixed) lease payments and lease incentives) Variable lease payments that depend on an index or a rate (e.g., the Consumer Price Index, a market interest rate) (refer to section 2.4.2, Variable lease payments that depend on an index or rate) The exercise price of a purchase option if the lessee is reasonably certain to exercise that purchase option (refer to section 2.4.3, The exercise price of a purchase option) Payments for penalties for terminating a lease, if the lease term reflects the lessee exercising an option to terminate the lease (refer to section 2.4.4, Payments for penalties for terminating a lease) Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction (refer to section 2.4.5, Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction) Amounts it is probable the lessee will owe under residual value guarantees (lessees only) (refer to section 2.4.6, Amounts it is probable that a lessee will owe under residual value guarantees lessees only) How we see it While ASC 842 does not specifically address non-cash lease payments (e.g., equity shares or stock options of the lessee provided to the lessor at lease inception), we believe a non-cash lease payment should be included in lease payments at its fair value Fixed (including in-substance fixed) lease payments and lease incentives In-substance fixed lease payments Leases Overall Implementation Guidance and Illustrations Lease payments include in substance fixed lease payments. In substance fixed payments are payments that may, in form, appear to contain variability but are, in effect, unavoidable. In substance fixed payments for a lessee or a lessor may include, for example, any of the following: a. Payments that do not create genuine variability (such as those that result from clauses that do not have economic substance) b. The lower of the payments to be made when a lessee has a choice about which set of payments it makes, although it must make at least one set of payments. Some lease agreements include payments that are described as variable or may appear to contain variability but are in-substance fixed payments because the contract terms ensure that the payment of a fixed amount is unavoidable. Such payments are included in the lease payments at lease commencement and thus used to measure entities lease assets and lease liabilities. 46 Technical Line A closer look at the new leases standard 31 March 2016

47 Lease incentives Leases Overall Implementation Guidance and Illustrations Lease incentives include both of the following: a. Payments made to or on behalf of the lessee b. Losses incurred by the lessor as a result of assuming a lessee s preexisting lease with a third party. In that circumstance, the lessor and the lessee should independently estimate any loss attributable to that assumption. For example, the lessee s estimate of the lease incentive could be based on a comparison of the new lease with the market rental rate available for similar underlying assets or the market rental rate from the same lessor without the lease assumption. The lessor should estimate any loss on the basis of the total remaining costs reduced by the expected benefits from the sublease of use of the assumed underlying asset. Variable lease payments that depend on an index or a rate are included in lease payments, but other variable lease payments are not. A lease agreement with a lessor might include incentives for the lessee to sign the lease, such as an up-front cash payment to the lessee, payment of costs for the lessee (such as moving expenses) or the assumption by the lessor of the lessee s preexisting lease with a third party. For lessees, lease incentives that are paid or payable to the lessee are deducted from lease payments and affect the lease classification test and reduce the initial measurement of a lessee s right-of-use asset. Lease incentives that are payable to the lessee at lease commencement reduce a lessee s lease liability. For lessors, lease incentives that are paid or payable to the lessee also are deducted from lease payments and affect the lease classification test. Lease incentives that are payable to the lessee at commencement reduce the initial measurement of the lessor s net investment in the lease for sales-type and direct financing leases. However, if lease incentives have been paid to the lessee prior to the commencement date, we believe that they affect the calculation of selling profit or loss for sales-type and direct financing leases. For operating leases, lessors should defer the cost of any lease incentives paid or payable to the lessee and recognize that cost as a reduction to lease income over the lease term. Refer to chapters 4, Lessee accounting, and 5, Lessor accounting Variable lease payments that depend on an index or rate Variable lease payments that depend on an index or a rate are included in the lease payments and are measured using the prevailing index or rate at the measurement date (e.g., lease commencement date for initial measurement). The FASB indicated in the Basis for Conclusions (BC 211) that despite the measurement uncertainty associated with changes to index- or rate-based payments, the payments meet the definition of an asset (lessor) and a liability (lessee) because they are unavoidable. Lessees and lessors recognize changes to index- and rate-based variable lease payments in profit or loss in the period of the change (i.e., similar to other variable lease payments) The exercise price of a purchase option If the lessee is reasonably certain to exercise a purchase option, the exercise price is included as a lease payment. That is, entities consider the exercise price of asset purchase options included in lease contracts consistently with the evaluation of lease renewal and termination options (refer to section 2.3.3, Evaluating lease term and purchase options). 47 Technical Line A closer look at the new leases standard 31 March 2016

48 2.4.4 Payments for penalties for terminating a lease If it is reasonably certain that the lessee will not terminate a lease, the lease term is determined assuming that the termination option would not be exercised, and any termination penalty is excluded from the lease payments. Otherwise, the lease termination penalty is included as a lease payment. The determination of whether to include lease termination penalties as lease payments is similar to the evaluation of lease renewal options Fees paid by the lessee to the owners of a special-purpose entity for structuring the transaction Fees paid by a lessee to the owners of a special-purpose entity for structuring a transaction are included as lease payments. However, such fees are excluded from the fair value of the underlying asset for purposes of the lease classification test. Refer to section 3.4.5, Fair value of the underlying asset Amounts it is probable that a lessee will owe under residual value guarantees lessees only ASC 842 requires a lessee to include the amount it is probable it will owe to a lessor under a residual value guarantee as lease payments. A lessee may provide a guarantee to the lessor that the value of the underlying asset it returns to the lessor at the end of the lease will be at least a specified amount. Such guarantees are enforceable obligations that the lessee has assumed by entering into the lease. Uncertainty related to the amount that a lessee will pay under a guarantee of a lessor s residual value affects the measurement of the obligation rather than the existence of an obligation. A lessee is required to remeasure and reallocate the remaining consideration in the contract and remeasure finance and operating lease liabilities when it changes its assessment of the amount it is probable that it will owe under a residual value guarantee. See section 4.4, Remeasurement of lease liabilities and right-of-use assets. Illustration 8 Residual value guarantee included in lease payments Entity R (lessee) enters into a lease and guarantees that the lessor will realize $15,000 from selling the asset to another party at the end of the lease. At lease commencement, based on Entity R s estimate of the residual value of the underlying asset, Entity R determines that it is probable that it will owe $6,000 at the end of the lease. Analysis: Because it is probable that Entity R will owe the lessor $6,000 under the residual value guarantee, Entity R includes that amount as a lease payment Third-party insurance that guarantees the asset s residual value Leases Overall Implementation Guidance and Illustrations A residual value guarantee obtained by the lessee from an unrelated third party for the benefit of the lessor should not be used to reduce the amount of the lessee's lease payments under paragraph (f) except to the extent that the lessor explicitly releases the lessee from obligation, including the secondary obligation, which is if the guarantor defaults, a residual value deficiency must be made up. Amounts paid in consideration for a guarantee by an unrelated third party are executory costs and are not included in the lessee's lease payments. 48 Technical Line A closer look at the new leases standard 31 March 2016

49 Lessees often guarantee the residual value and obtain an offsetting guarantee from an unrelated third party (e.g., an insurance company). A third-party guarantee can be used as a basis to reduce the lessee s lease payments only when (and to the extent) the lessor explicitly releases the lessee from the residual value guarantee (including any secondary obligation if the guarantor defaults). If the lessee is not removed as the primary or secondary guarantor under the lease by the lessor, the lessee should include the amount it is probable that it will owe under the residual value guarantee in lease payments. Amounts paid to the unrelated third party as consideration for the guarantee are executory costs and are not included in the lessee s lease payments Amounts not included in lease payments Leases Overall Initial Measurement Lease payments do not include any of the following: a. Variable lease payments other than those in paragraph (b) b. Any guarantee by the lessee of the lessor s debt c. Amounts allocated to nonlease components in accordance with paragraphs through Variable lease payments that do not depend on an index or rate Variable lease payments that do not depend on an index or rate, such as those based on performance (e.g., a percentage of sales) or usage of the underlying asset (e.g., the number of hours flown, the number of units produced), are not included as lease payments. A lessee s guarantee of a lessor s debt Lease payments do not include any guarantee by the lessee of the lessor s debt (which is generally accounted for under ASC 460, Guarantees). However, if the lessor s debt is recourse only to the leased asset either because the debt is non-recourse or the lessor has no significant assets other than the property under lease, we believe that a guarantee by the lessee of the lessor s debt is tantamount to guaranteeing the underlying asset s residual value. The same would be true for a non-recourse loan made by the lessee to the lessor. Accordingly, the probable shortfall between the outstanding debt balance and the value of the residual asset at the end of the lease term should be included in lease payments. In addition, the presence of a lessee s guarantee of the lessor s debt may affect the evaluation of both lease term and lease payments (e.g., the evaluation of whether a purchase option is reasonably certain to be exercised). Amounts allocated to non-lease components Lease payments do not include payments allocated to the non-lease components of a contract. However, lease payments include amounts that would otherwise be allocable to the non-lease components of a contract when the lessee makes an accounting policy election to account for the lease and non-lease components as a single lease component. Refer to sections , Allocating the consideration in the contract, and , Allocating the consideration in the contract, for lessees and lessors, respectively. 49 Technical Line A closer look at the new leases standard 31 March 2016

50 2.4.8 Subsequent remeasurement of lease payments Lessees Leases Overall Subsequent Measurement A lessee shall remeasure the lease payments if any of the following occur: a. The lease is modified, and that modification is not accounted for as a separate contract in accordance with paragraph b. A contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based is resolved such that those payments now meet the definition of lease payments. For example, an event occurs that results in variable lease payments that were linked to the performance or use of the underlying asset becoming fixed payments for the remainder of the lease term. c. There is a change in any of the following: 1. The lease term, as described in paragraph A lessee shall determine the revised lease payments on the basis of the revised lease term. 2. The assessment of whether the lessee is reasonably certain to exercise or not to exercise an option to purchase the underlying asset, as described in paragraph A lessee shall determine the revised lease payments to reflect the change in the assessment of the purchase option. 3. Amounts probable of being owed by the lessee under residual value guarantees. A lessee shall determine the revised lease payments to reflect the change in amounts probable of being owed by the lessee under residual value guarantees When a lessee remeasures the lease payments in accordance with paragraph , variable lease payments that depend on an index or a rate shall be measured using the index or rate at the remeasurement date. ASC 842 requires lessees to remeasure lease payments when there is a lease modification (i.e., a change to the terms and conditions of the contract that results in a change in the scope of or the consideration for the lease) that is not accounted for as a separate contract. Refer to the section 4.5, Lease modifications. Lessees are also required to remeasure lease payments if any of the following occur: A resolution of a contingency that results in some or all of the lease payments that were previously determined to be variable meeting the definition of lease payments (e.g., an event occurs that results in variable lease payments that were linked to the performance or use of the underlying asset becoming fixed payments for the remainder of the lease term) There is a change in any of the following: The lease term (section 2.3.1, Lease term) The assessment of whether the lessee is reasonably certain to exercise an option to purchase the underlying asset (section 2.3.2, Purchase options) The amounts it is probable that the lessee will owe under residual value guarantees (section 2.4.6, Amounts it is probable that a lessee will owe under residual value guarantees lessees only) 50 Technical Line A closer look at the new leases standard 31 March 2016

51 When lease payments are remeasured for any of the reasons discussed above, lessees will also remeasure variable lease payments that depend on an index or rate using the index or rate at the remeasurement date and remeasure and reallocate the remaining consideration in the contract. Lessees remeasure the lease liability at the reassessment date, with a corresponding adjustment to the right-of-use asset. However, if the right-of-use asset is reduced to zero, a lessee would recognize any remaining amount in profit or loss. Refer to chapter 4, Lessee accounting. Refer to Appendix B, Summary of lease reassessment and remeasurement requirements Lessors Leases Overall Subsequent Measurement A lessor shall not remeasure the lease payments unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph Lessors remeasure the lease payments only upon a modification (i.e., a change to the terms and conditions of the contract that results in a change in the scope of or the consideration for the lease) that is not accounted for as a separate contract. Refer to section 5.6, Lease modifications. Refer to Appendix B, Summary of lease reassessment and remeasurement requirements. 2.5 Discount rates Master Glossary Discount Rate for the Lease For a lessee, the discount rate for the lease is the rate implicit in the lease unless that rate cannot be readily determined. In that case, the lessee is required to use its incremental borrowing rate. For a lessor, the discount rate for the lease is the rate implicit in the lease. Rate Implicit in the Lease The rate of interest that, at a given date, causes the aggregate present value of (a) the lease payments and (b) the amount that a lessor expects to derive from the underlying asset following the end of the lease term to equal the sum of (1) the fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor and (2) any deferred initial direct costs of the lessor. Incremental Borrowing Rate The rate of interest that a lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. Leases Lessee Initial Measurement The discount rate for the lease initially used to determine the present value of the lease payments for a lessee is calculated on the basis of information available at the commencement date. 51 Technical Line A closer look at the new leases standard 31 March 2016

52 A lessee should use the rate implicit in the lease whenever that rate is readily determinable. If the rate implicit in the lease is not readily determinable, a lessee uses its incremental borrowing rate. A lessee that is not a public business entity is permitted to use a risk-free discount rate for the lease, determined using a period comparable with that of the lease term, as an accounting policy election for all leases. Leases Overall Recognition A lessor shall assess the criteria in paragraphs (d) and (b)(1) using the rate implicit in the lease. For purposes of assessing the criterion in paragraph (d), a lessor shall assume that no initial direct costs will be deferred if, at the commencement date, the fair value of the underlying asset is different from its carrying amount. Discount rates are used to determine the present value of the lease payments, which are used to determine lease classification (refer to chapter 3, Lease classification) and to measure a lessor s net investment in the lease for sales-type and direct financing leases and a lessee s lease liability. For a lessee, the discount rate for the lease is the rate implicit in the lease and, if that rate cannot be readily determined, its incremental borrowing rate. For a lessor, the discount rate for the lease is the rate implicit in the lease. The rate implicit in the lease is similar to the current definition in US GAAP and reflects the nature and specific terms of the lease Lessors Lessors use the rate implicit in the lease that causes the following: The present value of lease payments made by the lessee for the right to use the underlying asset The present value of the amount the lessor expects to derive from the underlying asset following the end of the lease term The fair value of the underlying asset minus any related investment tax credit retained and expected to be realized by the lessor + = + Any deferred initial direct costs of the lessor Initial direct costs classification For purposes of performing the sales-type lease classification test (refer to chapter 3, Lease classification), a lessor assumes that no initial direct costs will be deferred if, at the commencement date, the fair value of the underlying asset is different from its carrying amount. That is, initial direct costs are excluded from the calculation of the rate implicit in the lease in this case. Refer to section 2.6, Initial direct costs. Initial direct costs initial recognition and measurement For purposes of the initial recognition and measurement of a direct financing lease or a sales-type lease with no selling profit or loss, any initial direct costs are deferred and included in the computation of the rate implicit lease and therefore the net investment in the lease. The rate that was used in the sales-type lease classification test can differ from the rate used in the direct financing lease classification test and to initially measure the net investment in the lease because of the lease classification guidance above. 52 Technical Line A closer look at the new leases standard 31 March 2016

53 How we see it Using ASC 842 s definition of the rate implicit in the lease will be a key change in practice for lessors because they will include their initial direct costs for direct financing leases and sales-type leases with no selling profit or loss in the calculation of the rate implicit in the lease Lessees Lessees are required to use the rate implicit in the lease as described above if that rate can be readily determined. When the lessee cannot readily determine that rate, the lessee uses its incremental borrowing rate. The lessee s incremental borrowing rate is the rate of interest that the lessee would have to pay to borrow on a collateralized basis over a similar term an amount equal to the lease payments in a similar economic environment. Lessees that are not PBEs are permitted to make an accounting policy election to use the risk-free rate (e.g., in the US, the rate of a zero coupon US Treasury instrument) for the initial and subsequent measurement of lease liabilities. The risk-free rate is determined using a period comparable with the lease term. If a lessee makes this election, it must apply this policy to all leases and disclose it in the notes to the financial statements. How we see it The rate implicit in the lease is not necessarily the rate stated in the contract. In addition, the rate implicit in the lease reflects the lessor s initial direct costs for certain leases (as discussed above) and estimates of residual value. Therefore, lessees may find it difficult to determine the rate implicit in the lease. While using a risk-free rate might reduce complexity for eligible lessees, it would increase the likelihood that the present value of the lease payments and any residual value guaranteed by the lessee would equal or exceed substantially all of the fair value of the leased asset, potentially resulting in the lease being classified as a finance lease. Additionally, the use of a lower rate would increase the initial measurement of a lessee s lease liability and right-of-use asset. This might dissuade some lessees that aren t PBEs from making a policy election to use a risk-free rate Reassessment of the discount rate Lessors Lessors reassess the discount rate, for purposes of lease classification, upon a modification (i.e., a change to the terms and conditions of the contract that results in a change in the scope of or consideration for the lease) that is not accounted for as a separate contract. The discount rate that is used to account for the modified lease depends on the classification of the lease before and after the lease modification. Lessors use a revised discount rate to account for the modified lease upon any of the following: A modification (as described above) to an operating lease that is not accounted for as a separate contract, if the modified lease is classified as either a direct financing or a sales-type lease A modification (as described above) to a direct financing lease that is not accounted for as a separate contract, if the modified lease is classified as either a direct financing or a sales-type lease A modification (as described above) to a sales-type lease that is not accounted for as a separate contract, if the modified lease is classified as either a direct financing or a sales-type lease Refer to section 5.6, Lease modifications. Also refer to Appendix B, Summary of lease reassessment and remeasurement requirements. 53 Technical Line A closer look at the new leases standard 31 March 2016

54 Initial direct costs are incremental costs that would not have been incurred if the lease had not been obtained Lessees Lessees reassess the discount rate upon a change to the lease term or a change in the assessment of whether the lessee is reasonably certain to exercise an option to purchase the underlying asset if the discount rate for the lease liability (e.g., the lessee s incremental borrowing rate) does not already reflect the lessee s option in the lease to extend or terminate the lease or to purchase the underlying asset. That is, in such cases, a change in the discount rate is only required if the lessee had not accounted for the optionality in the contract when determining the discount rate previously. The reassessment is based on the remaining lease term and lease payments. Lessees are also required to reassess the discount rate upon a modification (i.e., a change to the terms and conditions of the contract that results in a change in the scope of or the consideration for the lease) that is not accounted for as a separate contract. Refer to section 4.5, Lease modifications. If a reassessment of the discount rate results in a change to the discount rate, lessees should remeasure the lease liability using the revised discount rate at the reassessment date and adjust the right-of-use asset. However, if the right-of-use asset is reduced to zero, a lessee should recognize any remaining amount in profit or loss. Refer to Appendix B, Summary of lease reassessment and remeasurement requirements. 2.6 Initial direct costs Master Glossary Initial Direct Costs Incremental costs of a lease that would not have been incurred if the lease had not been obtained. Leases Overall Initial Measurement Initial direct costs for a lessee or a lessor may include, for example, either of the following: a. Commissions b. Payments made to an existing tenant to incentivize that tenant to terminate its lease Costs to negotiate or arrange a lease that would have been incurred regardless of whether the lease was obtained, such as fixed employee salaries, are not initial direct costs. The following items are examples of costs that are not initial direct costs: a. General overheads, including, for example, depreciation, occupancy and equipment costs, unsuccessful origination efforts, and idle time b. Costs related to activities performed by the lessor for advertising, soliciting potential lessees, servicing existing leases, or other ancillary activities c. Costs related to activities that occur before the lease is obtained, such as costs of obtaining tax or legal advice, negotiating lease terms and conditions, or evaluating a prospective lessee s financial condition. 54 Technical Line A closer look at the new leases standard 31 March 2016

55 Under ASC 842, initial direct costs are incremental costs that would not have been incurred if the lease had not been obtained (e.g., commissions, payments made to an existing tenant to incentivize that tenant to terminate its lease). Lessees and lessors apply the same definition of initial direct costs. ASC 842 s guidance on initial direct costs is consistent with the concept of incremental costs of obtaining a contract in the new revenue recognition standard. ASC requires lessees to allocate initial direct costs to the separate lease components of a contract on the same basis as the lease payments (i.e., on a relative standalone price basis). Refer to section , Allocating the consideration in the contract. ASC also requires lessors to allocate any capitalized costs (e.g., initial direct costs, contract costs that are capitalizable in accordance with ASC , Other Assets and Deferred Costs Contracts with Customers) to the separate lease and non-lease components to which the costs relate. Refer to section , Allocating the consideration in the contract. How we see it Under ASC 842, the requirement that initial direct costs include only incremental costs that would not have been incurred if the lease hadn t been obtained will result in a key change in practice. Lessees and lessors will no longer include allocated costs (e.g., salaries) and costs incurred before the lease is obtained (e.g., negotiating costs, legal advice) in initial direct costs. The following table summarizes how lessees and lessors account for initial direct costs (i.e., incremental costs of a lease that would not have been incurred if the lease had not been obtained) that are capitalized at the date the lease is obtained (which may be before lease commencement) and allocate them to the lease components of the contract. Lessees Lessors* Lease classification Finance lease Operating lease Sales-type lease with selling profit or loss Sales-type lease with no selling profit or loss Direct financing lease with selling profit or loss Direct financing lease with no selling profit or loss Operating lease Accounting for capitalized initial direct costs (IDCs) Include IDCs in the initial and subsequent measurement of the right-of-use asset. Refer to chapter 4, Lessee accounting. Expense IDCs at lease commencement. Refer to chapter 5, Lessor accounting. Include IDCs in the initial and subsequent measurement of the net investment in the lease. Refer to chapter 5, Lessor accounting. Recognize IDCs as expense over the lease term on the same basis as lease income * As discussed in section 2.5.1, Lessors, for purposes of performing the sales-type lease classification test only, a lessor assumes that no initial direct costs will be deferred (i.e., initial direct costs are excluded from the calculation of the rate implicit in the lease) if, at the commencement date, the fair value of the underlying asset is different from its carrying amount. Refer to chapter 3, Lease classification, for further discussion. 55 Technical Line A closer look at the new leases standard 31 March 2016

56 ASC 842 includes the following example of the accounting for initial direct costs. Leases Overall Implementation Guidance and Illustrations Lessee and Lessor enter into an operating lease. The following costs are incurred in connection with the lease: Travel costs related to lease proposal $ 7,000 External legal fees 22,000 Allocation of employee costs for time negotiating lease terms and conditions 6,000 Commissions to brokers 10,000 Total costs incurred by Lessor $ 45,000 External legal fees $ 15,000 Allocation of employee costs for time negotiating leases terms and conditions 7,000 Payments made to existing tenant to obtain the lease 20,000 Total costs incurred by Lessee $ 42, Lessor capitalizes initial direct costs of $10,000, which it recognizes ratably over the lease term, consistent with its recognition of lease income. The $10,000 in broker commissions is an initial direct cost because that cost was incurred only as a direct result of obtaining the lease (that is, only as a direct result of the lease being executed). None of the other costs incurred by Lessor meet the definition of initial direct costs because they would have been incurred even if the lease had not been executed. For example, the employee salaries are paid regardless of whether the lease is obtained, and Lessor would be required to pay its attorneys for negotiating and drafting the lease even if Lessee did not execute the lease Lessee includes $20,000 of initial direct costs in the initial measurement of the right-of-use asset. Lessee amortizes those costs ratably over the lease term as part of its total lease cost. Throughout the lease term, any unamortized amounts from the original $20,000 are included in the measurement of the right-of-use asset. The $20,000 payment to the existing tenant is an initial direct cost because that cost is only incurred upon obtaining the lease; it would not have been owed if the lease had not been executed. None of the other costs incurred by Lessee meet the definition of initial direct costs because they would have been incurred even if the lease had not been executed (for example, the employee salaries are paid regardless of whether the lease is obtained, and Lessee would be required to pay its attorneys for negotiating and drafting the lease even if the lease was not executed) Initial direct costs in a lease modification Lessees and lessors account for costs incurred in a lease modification (i.e., a change to the terms and conditions of the contract that results in a change in the scope of or the consideration for the lease) that meet the definition of initial direct costs in the same manner as those items are accounted for in connection with a new lease. A lessee s initial direct costs in a lease modification are included in the measurement of the new right-of-use asset (i.e., for a modification that is accounted for as a separate contract) or the adjustment to the right-of-use asset (i.e., for a modification that is not accounted for as a separate contract). 56 Technical Line A closer look at the new leases standard 31 March 2016

57 A lessor accounts for initial direct costs in a lease modification based on the classification of the new lease as follows: For sales-type leases with selling profit or loss, expense initial direct costs on the effective date of the modification For sales-type leases with no selling profit or loss and direct financing leases, initial direct costs allocated to the lease component are included in the measurement of the new net investment in the lease (i.e., for a modification that is accounted for as a separate contract) or the adjustment to the net investment in the lease (i.e., for a modification that is not accounted for as a separate contract) For operating leases, capitalize and expense initial direct costs over the lease term on the same basis as lease income for those costs allocated to the lease component Refer to section 4.5, Lease modifications, and 5.6, Lease modifications. 2.7 Economic life Master Glossary Economic Life Either the period over which an asset is expected to be economically usable by one or more users or the number of production or similar units expected to be obtained from an asset by one or more users. ASC 842 defines the economic life of an asset as either: The period over which an asset is expected to be economically usable by one or more users The number of production or similar units expected to be obtained from the asset by one or more users This definition of economic life, while not the same as the definition in ASC 840, is not expected to significantly change economic life estimates. We believe that economically usable means that the asset is or is expected to be viable from an economic perspective. In addition, we believe that one or more users means the existing lessee plus any successor lessees or owners. 2.8 Fair value Leases Overall Master Glossary Fair Value (second definition) The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Orderly Transaction A transaction that assumes exposure to the market for a period before the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale). 57 Technical Line A closer look at the new leases standard 31 March 2016

58 Market Participants Buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics: a. They are independent of each other, that is, they are not related parties, although the price in a related-party transaction may be used as an input to a fair value measurement if the reporting entity has evidence that the transaction was entered into at market terms b. They are knowledgeable, having a reasonable understanding about the asset or liability and the transaction using all available information, including information that might be obtained through due diligence efforts that are usual and customary c. They are able to enter into a transaction for the asset or liability d. They are willing to enter into a transaction for the asset or liability, that is, they are motivated but not forced or otherwise compelled to do so. In a change from ASC 840, lessees and lessors determine the fair value of the underlying asset in a lease arrangement for purposes of lease classification and measurement under ASC 842 using the definition of fair value in ASC 820, Fair Value Measurement. That is, the fair value of the underlying asset in a lease arrangement is the price that would be received to sell the asset in an orderly transaction between market participants at the measurement date. ASC 820 provides a framework for measuring fair value and requires certain disclosures. How we see it While ASC 842 does not prohibit lessees from recognizing a right-of-use asset that exceeds the fair value of the underlying asset, we believe that lessees should challenge the inputs and assumptions used to measure the right-of-use asset if the carrying amount of the right-of-use asset exceeds the fair value of the underlying asset. Inputs and assumptions that could be challenged include the identification of lease and non-lease components, the allocation of consideration in the contract to those components and the discount rate used. 2.9 Related party leasing transactions Leases Overall Implementation Guidance and Illustrations Leases between related parties should be classified in accordance with the lease classification criteria applicable to all other leases on the basis of the legally enforceable terms and conditions of the lease. In the separate financial statements of the related parties, the classification and accounting for the leases should be the same as for leases between unrelated parties. ASC 842 requires lessees and lessors to classify and account for leases between related parties on the basis of the legally enforceable terms and conditions of the lease (i.e., in the same manner as leases between unrelated parties). This eliminates the current requirement under US GAAP for lessees and lessors to evaluate the economic substance of a lease to determine the appropriate accounting. Under ASC 842, lessees and lessors will still be required to apply the disclosure requirements for related party transactions in accordance with ASC 850, Related Party Disclosures. These requirements include disclosing the nature of the relationships and a description of the transactions, including information deemed necessary to understand the effects of the transactions on the financial statements. Additionally, these disclosures should not imply that a transaction is at arm s length unless such an assertion can be substantiated. 58 Technical Line A closer look at the new leases standard 31 March 2016

59 3 Lease classification Leases Overall Recognition A lessee shall classify a lease as a finance lease and a lessor shall classify a lease as a sales-type lease when the lease meets any of the following criteria at lease commencement: a. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term. b. The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise. c. The lease term is for the major part of the remaining economic life of the underlying asset. However, if the commencement date falls at or near the end of the economic life of the underlying asset, this criterion shall not be used for purposes of classifying the lease. d. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph (f) equals or exceeds substantially all of the fair value of the underlying asset. e. The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term When none of the criteria in paragraph are met: a. A lessee shall classify the lease as an operating lease. b. A lessor shall classify the lease as either a direct financing lease or an operating lease. A lessor shall classify the lease as an operating lease unless both of the following criteria are met, in which case the lessor shall classify the lease as a direct financing lease: 1. The present value of the sum of the lease payments and any residual value guaranteed by the lessee that is not already reflected in the lease payments in accordance with paragraph (f) and/or any other third party unrelated to the lessor equals or exceeds substantially all of the fair value of the underlying asset. 2. It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee A lessor shall assess the criteria in paragraphs (d) and (b)(1) using the rate implicit in the lease. For purposes of assessing the criterion in paragraph (d), a lessor shall assume that no initial direct costs will be deferred if, at the commencement date, the fair value of the underlying asset is different from its carrying amount. 59 Technical Line A closer look at the new leases standard 31 March 2016

60 Under ASC 842, lessees and lessors classify leases at the lease commencement date (except when the lessee elects the short-term lease exception discussed in section 4.1.1, Short-term leases). Lessees classify leases as either finance leases or operating leases. Lessors classify leases as sales-type leases, direct financing leases or operating leases. Lease classification determines how and when a lessee and a lessor recognize lease expense and income, respectively, and what assets and liabilities they record. The criteria used for lease classification are discussed in detail below. How we see it While ASC 842 and ASC 840 use the same or similar terms for lease types for lessees and lessors, lease classification under the two standards could differ because the classification tests are not identical. See section 3.5, Comparison of the lease classification tests in ASC 842 and ASC Criteria for lease classification lessees At lease commencement, a lessee classifies a lease as a finance lease if the lease meets any one of the following criteria: Lessees and lessors classify leases at the lease commencement date. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term (refer to section 3.4.1, Transfer of ownership). The lease grants the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise (refer to section 2.3.3, Evaluating lease term and purchase options). The lease term (refer to section 2.3.1, Lease term) is for a major part of the remaining economic life (refer to section 2.7, Economic life) of the underlying asset. This criterion is not applicable for leases that commence at or near the end of the underlying asset s economic life (refer to section 3.4.2, Evaluating major part, substantially all and at or near the end ). The present value of the sum of the lease payments (refer to section 2.4, Lease payments) and any residual value guaranteed by the lessee (refer to section 3.4.4, Residual value guarantees included in the lease classification test) that is not already included in the lease payments equals or exceeds substantially all of the fair value (refer to section 2.8, Fair value) of the underlying asset (refer to sections 3.4.2, Evaluating major part, substantially all and at or near the end ). The underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term (refer to section 3.4.6, Alternative use criterion). A lessee classifies a lease as an operating lease when it does not meet any one of the criteria above. ASC 842 s lease classification criteria for lessees are similar to those in ASC 840 except for the alternative use criterion, which is new under ASC 842. Refer to section 3.5, Comparison of the lease classification tests in ASC 842 and ASC 840, for discussion of other changes to the classification criteria. 60 Technical Line A closer look at the new leases standard 31 March 2016

61 3.2 Criteria for lease classification lessors At lease commencement, a lessor classifies a lease as a sales-type lease if the lease meets any one of the criteria in section 3.1, Criteria for lease classification lessees. If none of the criteria in section 3.1, Criteria for lease classification lessees, are met, a lessor classifies a lease as a direct financing lease when the lease meets both of the following criteria: The present value of the sum of lease payments and any residual value guaranteed by the lessee and any other third party unrelated to the lessor equals or exceeds substantially all the fair value of the underlying asset. It is probable that the lessor will collect the lease payments plus any amount necessary to satisfy a residual value guarantee. For lessors, all leases not classified as sales-type leases or direct financing leases are classified as operating leases. A key difference between the sales-type and direct financing lease classification tests is the treatment of residual value guarantees provided by unrelated third parties. A key difference between the sales-type lease and direct financing lease classification tests is the treatment of residual value guarantees provided by unrelated third parties other than the lessee. Those third-party guarantees are excluded from the evaluation of the substantially all criterion in the sales-type lease test. However, they are included in the evaluation in the direct financing lease test. In addition, the evaluation of the collectibility of lease payments and residual value guarantees affects direct financing lease classification, whereas it does not affect sales-type lease classification. However, the evaluation of collectiblity does affect sales-type lease recognition and measurement. The lease classification test is designed so that a direct financing lease involves a residual value guarantee from an unrelated third party other than the lessee that is sufficient to satisfy the substantially all criterion. Although a residual value guarantee from an unrelated third party other than the lessee can exist in a sales-type or an operating lease, a lease without a residual value guarantee from an unrelated third party other than the lessee must be classified as either a sales-type or an operating lease. The decision tree below summarizes the evaluation of lease classification for lessors under ASC 842. Does the lease meet any one of the criteria in section 3.1, Criteria for lease classification lessees (ASC )? Yes Sales-type lease* No Does the lease meet both of the following criteria in section 3.2, Criteria for lease classification lessors (ASC )? The present value of the sum of the lease payments and any residual value guaranteed by the lessee and any other third party unrelated to the lessor equals or exceeds substantially all the fair value of the underlying asset. It is probable that the lessor will collect the lease payments plus any amounts necessary to satisfy a residual value guarantee. No Operating lease Yes Direct financing lease * ASC 842 does not require lessors to assess the collectibility of lease payments and any residual value guarantee provided by the lessee in the sales-type lease classification test. However, lessors are required to assess the collectibility of lease payments and any residual value guarantee provided by the lessee to determine the recognition and initial measurement of sales-type leases. Refer to section 5.2, Sales-type leases, on the accounting for sales-type leases. 61 Technical Line A closer look at the new leases standard 31 March 2016

62 3.3 Discount rates used to determine lease classification Discount rates are used to determine the present value of the lease payments an entity will use to evaluate the substantially all criterion in the finance lease classification test for lessees and the sales-type and direct financing lease classification tests for lessors Lessees For lessees, the discount rate used to evaluate the substantially all criterion is the rate implicit in the lease or the lessee s incremental borrowing rate, if the rate implicit in the lease cannot be readily determined. Refer to section 2.5, Discount rates Lessors Sales-type lease classification test The discount rate used to evaluate the substantially all criterion in the sales-type lease classification test (as described in ASC (d)) is the rate implicit in the lease (refer to section 2.5, Discount rates). However, a lessor assumes that none of its initial direct costs (refer to section 2.6, Initial direct costs) will be deferred (i.e., initial direct costs are excluded from the calculation of the rate implicit in the lease) if, at the commencement date, the fair value of the underlying asset is different from its carrying amount. If the fair value of the underlying asset is the same as its carrying amount at lease commencement, a lessor includes initial direct costs in the calculation of the rate implicit in the lease. Direct financing lease classification test The discount rate used to evaluate the substantially all criterion in the direct financing lease classification test (as described in ASC (b)(1)) is the rate implicit in the lease (refer to section 2.5, Discount rates). The following table summarizes the discount rates used to determine lease classification by lessors. Sales-type lease classification test (as described in ASC (d)) Direct financing lease classification test (as described in ASC (b)(1)) * Includes initial direct costs At lease commencement, the fair value of the underlying asset does not equal its carrying value Rate implicit in the lease, assuming that no initial direct costs of the lessor will be deferred (i.e., exclude initial direct costs from the calculation of the rate implicit in the lease) Rate implicit in the lease* At lease commencement, the fair value of the underlying asset is equal to its carrying value Rate implicit in the lease* Rate implicit in the lease* 3.4 Lease classification considerations Transfer of ownership Leases Overall Implementation Guidance and Illustrations The criterion in paragraph (a) is met in leases that provide, upon the lessee s performance in accordance with the terms of the lease, that the lessor should execute and deliver to the lessee such documents (including, if applicable, a bill of sale) as may be required to release the underlying asset from the lease and to transfer ownership to the lessee. 62 Technical Line A closer look at the new leases standard 31 March 2016

63 The criterion in paragraph (a) also is met in situations in which the lease requires the payment by the lessee of a nominal amount (for example, the minimum fee required by the statutory regulation to transfer ownership) in connection with the transfer of ownership A provision in a lease that ownership of the underlying asset is not transferred to the lessee if the lessee elects not to pay the specified fee (whether nominal or otherwise) to complete the transfer is an option to purchase the underlying asset. Such a provision does not satisfy the transfer-of-ownership criterion in paragraph (a). A lease is classified as a finance lease by a lessee and a sales-type lease by a lessor if the lease transfers ownership of the underlying asset to the lessee by the end of the lease term (e.g., through the transfer of title). Consistent with the guidance in ASC 840, this includes the transfer of ownership of the underlying asset to the lessee at or shortly after the end of the lease term in exchange for no additional consideration or the payment of a nominal amount (e.g., the minimum fee required by statutory regulation to transfer ownership). A provision in a lease agreement that ownership of the underlying asset does not transfer if the lessee elects not to pay a specified fee (nominal or otherwise) to complete the transfer is a purchase option and not an automatic transfer of ownership (refer to section 2.3.2, Purchase options) Evaluating major part, substantially all and at or near the end Leases Overall Implementation Guidance and Illustrations When determining lease classification, one reasonable approach to assessing the criteria in paragraphs (c) through (d) and (b)(1) would be to conclude: a. Seventy-five percent or more of the remaining economic life of the underlying asset is a major part of the remaining economic life of that underlying asset. b. A commencement date that falls at or near the end of the economic life of the underlying asset refers to a commencement date that falls within the last 25 percent of the total economic life of the underlying asset. c. Ninety percent or more of the fair value of the underlying asset amounts to substantially all the fair value of the underlying asset. The terms major part, substantially all and at or near the end are not defined in ASC 842. However, ASC 842 includes implementation guidance that states that one reasonable approach to lease classification is to conclude, consistent with ASC 840, that 75% or greater is a major part of the remaining economic life of an underlying asset, 90% or greater is substantially all the fair value of the underlying asset and the last 25% of the total economic life of the underlying asset is at or near the end. We believe an entity should establish accounting policies for its thresholds used to determine lease classification, have a reasonable basis for those policies if they differ from the reasonable approach articulated in the standard and apply those policies consistently. 63 Technical Line A closer look at the new leases standard 31 March 2016

64 3.4.3 Lease component that contains the right to use more than one underlying asset Leases Overall Recognition If a single lease component contains the right to use more than one underlying asset (see paragraphs through 15-29), an entity shall consider the remaining economic life of the predominant asset in the lease component for purposes of applying the criterion in paragraph (c). If a lease component contains the right to use more than one underlying asset, the remaining economic life of the predominant asset is used to determine lease classification. Refer to section 1.4.1, Identifying and separating lease components of a contract, for further discussion of assessing whether a lease contains multiple lease components Residual value guarantees included in the lease classification test A lessee is required to include the full amount of a residual value guarantee it provides to a lessor (i.e., its maximum obligation) in its evaluation of the substantially all criterion of the lease classification test (i.e., in its evaluation of ASC (d)). A lessor is also required to include the full amount of a residual value guarantee provided by a lessee in its evaluation of whether a lease is a sales-type lease. However, if a lease does not qualify as a sales-type lease, a lessor includes the full amounts of residual value guarantees provided by both lessees and any other third party unrelated to the lessor in its evaluation of the substantially all criterion of the lease classification test to determine whether a lease is a direct financing lease (i.e., in its evaluation of ASC (b)(1)). Residual value guarantees are treated differently when determining lease payments (i.e., for purposes of recognizing the lease as opposed to classifying the lease). A lessee includes the amount that it is probable it will owe to the lessor under a residual value guarantee as a lease payment. Lessors exclude residual guarantees from lease payments. Refer to section 2.4, Lease payments Fair value of the underlying asset Leases Overall Implementation Guidance and Illustrations In some cases, it may not be practicable for an entity to determine the fair value of an underlying asset. In the context of this Topic, practicable means that a reasonable estimate of fair value can be made without undue cost or effort. It is a dynamic concept; what is practicable for one entity may not be practicable for another, what is practicable in one period may not be practicable in another, and what is practicable for one underlying asset (or class of underlying asset) may not be practicable for another. In those cases in which it is not practicable for an entity to determine the fair value of an underlying asset, lease classification should be determined without consideration of the criteria in paragraphs (d) and (b)(1). 64 Technical Line A closer look at the new leases standard 31 March 2016

65 In some cases, it may not be practicable for an entity to determine the fair value (refer to section 2.8, Fair value) of an underlying asset. This may be the case when the underlying asset is part of a larger asset (e.g., one floor in a multi-floor office building, one store in a shopping center). If a reasonable estimate of fair value cannot be made without undue cost or effort, lessees and lessors will not evaluate the substantially all classification criterion described in sections 3.1, Criteria for lease classification lessees, and 3.2, Criteria for lease classification lessors. Instead, lease classification will be based on the remaining classification criteria described in section 3.1, Criteria for lease classification lessees. Fees paid by a lessee to the owners of a special-purpose entity for structuring a transaction are included as lease payments (refer to section 2.4, Lease payments). However, such fees are excluded from the fair value of the underlying asset for purposes of the lease classification test Effect of investment tax credits Leases Overall Implementation Guidance and Illustrations When evaluating the lease classification criteria in paragraphs (d) and (b)(1), the fair value of the underlying asset should exclude any related investment tax credit retained by the lessor and expected to be realized by the lessor. When an entity calculates the fair value of an underlying asset to evaluate the substantially all classification criterion in the lease classification tests discussed in sections 3.1, Criteria for lease classification lessees, and 3.2, Criteria for lease classification lessors, the fair value of the underlying asset should exclude any related investment tax credits retained by the lessor and expected to be realized by the lessor Alternative use criterion Leases Overall Implementation Guidance and Illustrations In assessing whether an underlying asset has an alternative use to the lessor at the end of the lease term in accordance with paragraph (e), an entity should consider the effects of contractual restrictions and practical limitations on the lessor s ability to readily direct that asset for another use (for example, selling it or leasing it to an entity other than the lessee). A contractual restriction on a lessor s ability to direct an underlying asset for another use must be substantive for the asset not to have an alternative use to the lessor. A contractual restriction is substantive if it is enforceable. A practical limitation on a lessor s ability to direct an underlying asset for another use exists if the lessor would incur significant economic losses to direct the underlying asset for another use. A significant economic loss could arise because the lessor either would incur significant costs to rework the asset or would only be able to sell or re-lease the asset at a significant loss. For example, a lessor may be practically limited from redirecting assets that either have design specifications that are unique to the lessee or that are located in remote areas. The possibility of the contract with the customer being terminated is not a relevant consideration in assessing whether the lessor would be able to readily direct the underlying asset for another use. 65 Technical Line A closer look at the new leases standard 31 March 2016

66 A lease is classified as a finance lease by a lessee and a sales-type lease by a lessor if the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. The FASB indicated in the Basis for Conclusions (BC 71(e)) that lessors generally would lease specialized assets that have no alternative use to them at the end of the lease term under terms that would transfer substantially all the benefits (and risks) of the asset to the lessee. That is, when this criterion is met, it is likely that one of the other criteria described in section 3.1, Criteria for lease classification lessees, will also be met. An exception could be when a significant amount of anticipated lease payments are in the form of variable lease payments that do not depend on an index or rate. When assessing whether an underlying asset has an alternative use to the lessor at the end of the lease term, lessees and lessors should consider the effects of substantive contractual restrictions and practical limitations on the lessor s ability to readily direct that asset for another use (e.g., sell it, re-lease it). A practical limitation exists if the lessor would incur significant economic losses to repurpose the underlying asset for another use (e.g., if the lessor either would incur significant costs to rework the asset or would only be able to sell or re-lease the asset at a significant loss) Lessee indemnifications for environmental contamination Leases Overall Implementation Guidance and Illustrations A provision that requires lessee indemnification for environmental contamination, whether for environmental contamination caused by the lessee during its use of the underlying asset over the lease term or for preexisting environmental contamination, should not affect the classification of the lease. A provision that requires lessee indemnifications for preexisting environmental contamination or environmental contamination caused by the lessee during its use of the underlying asset over the term of the lease does not affect classification of the lease. Indemnities for preexisting environmental contamination are accounted for under ASC 460, whereas indemnities for contamination caused by the lessee during the lease term are excluded from the requirements of ASC 460 as they represent a guarantee of the lessee s own performance. Contamination caused by the lessee during the lease term is accounted for under ASC , Environmental obligations Classification of subleases Leases Overall Implementation Guidance and Illustrations When classifying a sublease, an entity shall classify the sublease with reference to the underlying asset (for example, the item of property, plant, or equipment that is the subject of the lease) rather than with reference to the right-of-use asset. Lessees often enter into arrangements to sublease a leased asset to a third party while the original lease contract is in effect. In these arrangements, one party acts as both the lessee and lessor of the same underlying asset. The original lease is often referred to as a head lease, the original lessee is often referred to as a sublessor and the ultimate lessee is often referred to as the sublessee. 66 Technical Line A closer look at the new leases standard 31 March 2016

67 Under ASC 842, a sublessor assesses sublease classification independently of the classification assessment that it makes as the lessee of the same asset. A sublessor considers the lease classification criteria for lessors, discussed in section 3.2, Criteria for lease classification lessors, with reference to the underlying asset (i.e., the item of property, plant or equipment that is the subject of the lease) when classifying a sublease. Refer to chapter 6, Subleases, for further discussion of the accounting for subleases. A sublessee assesses classification of the sublease in the same manner as any other lease using the criteria discussed in section 3.1, Criteria for lease classification lessees. 3.5 Comparison of the lease classification tests in ASC 842 and ASC 840 Although ASC 842 s lease classification criteria are similar to those in ASC 840, some differences that could result in leases being classified differently under ASC 842 include: ASC 842 requires lessees and lessors to perform the lease classification test at the lease commencement date. Under ASC 840, this test is performed at the lease inception date. ASC 842 requires lessees and lessors to evaluate as part of the lease classification test whether the underlying asset is of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term. This criterion is not included in ASC 840. Refer to section 3.4.6, Alternative use criterion. ASC 842 eliminates the bright-line criteria that exist in ASC 840 (e.g., the 75% of economic life and 90% of fair value criteria). Instead, lessees and lessors will need to exercise judgment when evaluating whether the lease term is for the major part of the remaining economic life of the underlying asset and whether the present value of lease payments equals or exceeds substantially all of the fair value of the underlying asset. However, ASC states that one reasonable approach to these tests would be to conclude that [s]eventy-five percent or more of the remaining economic life of the underlying asset is a major part and [n]inety percent or more of the fair value of the underlying asset amounts to substantially all of the fair value of the underlying asset. ASC 842 eliminates the real estate-specific classification criteria in ASC 840. For example, under ASC 840, only the transfer of ownership and bargain purchase criteria are considered when evaluating the classification of land leases. As a result, the classification of some land lease arrangements could change under ASC 842. ASC 840 requires lessors to consider four lease classification criteria applicable to lessees and both of the following criteria: (1) collectibility of the minimum lease payments is reasonably predictable, and (2) no important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease. ASC 842 eliminates the requirement for lessors to evaluate the no important uncertainties criterion and changes the collectibility assessment. Under ASC 842, lessors do not assess the collectibility of lease payments and any residual value guarantee provided by a lessee when evaluating whether a lease should be classified as a sales-type lease. However, the collectibility assessment will affect the initial recognition and measurement of sales-type leases. Refer to section 5.1.3, Collectibility. ASC 842 eliminates leveraged lease classification for new leases on or after the effective date. Refer to section 5.7.5, Leveraged leases. ASC 842 eliminates the requirement that a lease must give rise to selling profit or loss to be classified as a sales-type lease for lessors. Therefore, the lease classification test under ASC 842 could result in arrangements being classified as sales-type leases with no selling profit or loss and direct financing leases with selling profit or loss. 67 Technical Line A closer look at the new leases standard 31 March 2016

68 ASC 842 eliminates the guidance in ASC 840 that precludes an entity from considering the substantially all criterion when the underlying asset is in the last 25% of its estimated economic life but says entities are precluded from considering the economic life criterion when the underlying asset is at or near the end its economic life consistent with ASC 840. Refer to sections 2.7, Economic life and 3.4.2, Evaluating major part, substantially all and at or near the end. 3.6 Reassessment of lease classification Leases Overall Recognition An entity shall classify each separate lease component at the commencement date. An entity shall not reassess the lease classification after the commencement date unless the contract is modified and the modification is not accounted for as a separate contract in accordance with paragraph In addition, a lessee also shall reassess the lease classification after the commencement date if there is a change in the lease term or the assessment of whether the lessee is reasonably certain to exercise an option to purchase the underlying asset. Lessees and lessors are required to reassess lease classification upon a modification (i.e., a change to the terms and conditions of the contract that results in a change in the scope of or the consideration for the lease) that is not accounted for as a separate contract. Refer to section 4.5, Lease modifications, and section 5.6, Lease modifications, for a discussion of which modifications are accounted for as separate contracts for lessees and lessors, respectively. Lessees and lessors reassess lease classification as of the effective date of a modification to a contract (i.e., an agreement between two or more parties that creates enforceable rights and obligations) using the modified terms and conditions and the facts and circumstances as of that date including: The remaining economic life of the underlying asset on that date The fair value of the underlying asset on that date The discount rate for the lease on that date The remeasurement and reallocation of the remaining consideration in the contract on that date If a modification to a contract is accounted for as a separate contract that contains a lease, that separate lease is classified in the same manner as any new lease. Refer to sections 3.1, Criteria for lease classification lessees, and 3.2, Criteria for lease classification lessors. Lessees are also required to reassess lease classification when there is a change in their assessment of either the lease term or whether they are reasonably certain to exercise an option to purchase the underlying asset. Refer to section 2.3.4, Reassessment of the lease term and purchase options. Refer to Appendix B, Summary of lease reassessment and remeasurement requirements. 68 Technical Line A closer look at the new leases standard 31 March 2016

69 4 Lessee accounting 4.1 Initial recognition Leases Lessee Recognition At the commencement date, a lessee shall recognize a right-of-use asset and a lease liability. Master Glossary Short-Term Lease A lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. Right-of-Use Asset An asset that represents a lessee s right to use an underlying asset for the lease term. Lease Liability A lessee s obligation to make the lease payments arising from a lease, measured on a discounted basis. Leases Lessee Recognition As an accounting policy, a lessee may elect not to apply the recognition requirements in this Subtopic to short-term leases. Instead, a lessee may recognize the lease payments in profit or loss on a straight-line basis over the lease term and variable lease payments in the period in which the obligation for those payments is incurred (consistent with paragraphs through 55-2). The accounting policy election for short-term leases shall be made by class of underlying asset to which the right of use relates If the lease term or the assessment of a lessee option to purchase the underlying asset changes such that, after the change, the remaining lease term extends more than 12 months from the end of the previously determined lease term or the lessee is reasonably certain to exercise its option to purchase the underlying asset, the lease no longer meets the definition of a short-term lease and the lessee shall apply the remainder of the guidance in this Topic as if the date of the change in circumstances is the commencement date. At the commencement date of a lease, a lessee recognizes a liability to make lease payments (i.e., the lease liability) and an asset representing the right to use the underlying asset during the lease term (i.e., the right-of-use asset). The initial recognition of the right-of-use asset and the lease liability is the same for operating leases and finance leases as is the subsequent measurement of the lease liability. However, the subsequent measurement of the right-of-use asset for operating leases and finance leases differs under ASC 842. Refer to section , Right-of-use assets, and , Right-of-use assets, on subsequent measurement of right-out-use assets for operating leases and finance leases, respectively. 69 Technical Line A closer look at the new leases standard 31 March 2016

70 4.1.1 Short-term leases Lessees can make an accounting policy election (by class of underlying asset to which the right of use relates) to apply accounting similar to ASC 840 s operating lease accounting to leases that meet ASC 842 s definition of a short-term lease (i.e., the short-term lease exception). A short-term lease is defined as a lease that, at the commencement date, has a lease term of 12 months or less and does not include an option to purchase the underlying asset that the lessee is reasonably certain to exercise. A lessee that makes this accounting policy election does not recognize a lease liability or right-of-use asset on its balance sheet. Instead, the lessee recognizes lease payments as expense on a straight-line basis over the lease term and variable lease payments that do not depend on an index or rate as expense in the period in which the achievement of the specified target that triggers the variable lease payments becomes probable. Any recognized variable lease expense is reversed when it is probable that the specified target will no longer be met. Refer to section 2.4.7, Amounts not included in lease payments, for a discussion of variable lease payments that do not depend on an index or rate. Lessees can make an accounting policy election (by class of underlying asset) not to recognize right-of-use assets and lease liabilities for short-term leases. When determining whether a lease qualifies as a short-term lease, a lessee evaluates the lease term and the purchase option in the same manner as all other leases. Refer to section 2.3, Lease term and purchase options. That is, the lease term includes the noncancellable term of the lease and all of the following: Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option Periods covered by an option to extend (or not terminate) the lease in which the exercise of the option is controlled by the lessor A lease that qualifies as a short-term lease at the commencement date no longer meets the definition of a short-term lease when there is a change in a lessee s assessment of either: The lease term so that, after the change, the remaining lease term extends more than 12 months from the end of the previously determined lease term Whether it is reasonably certain to exercise an option to purchase the underlying asset When the lease no longer meets the definition of a short-term lease, a lessee that is applying the short-term lease exception must apply the recognition and measurement guidance for all other leases as if the date of the change in circumstances is the commencement date. The short-term lease accounting policy election is intended to reduce the cost and complexity of applying ASC 842. However, a lessee that makes the election must make certain quantitative and qualitative disclosures about short-term leases. Refer to section 4.8, Disclosure. Once a lessee establishes a policy for a class of underlying assets, all future short-term leases for that class are required to be accounted for in accordance with the lessee s policy. A lessee evaluates any potential change in its accounting policy in accordance with the guidance in ASC 250, Accounting Changes and Error Corrections. 70 Technical Line A closer look at the new leases standard 31 March 2016

71 Illustration 9 Short-term lease Scenario A A lessee enters into a lease with a nine-month noncancellable term with an option to extend the lease for four months. The lease does not include a purchase option. At the lease commencement date, the lessee concludes that it is reasonably certain to exercise the extension option because the monthly lease payments during the extension period are significantly below market rates. The lessee has an established accounting policy to use the short-term lease exception for the class of underlying asset subject to this lease. Analysis: The lease term is greater than 12 months (i.e., 13 months). Therefore, the lessee may not account for the lease as a short-term lease. Scenario B Assume the same facts as in Scenario A except, at the lease commencement date, the lessee concludes that it is not reasonably certain to exercise the extension option because the monthly lease payments during the optional extension period are what the lessee expects to be market rates, and there are no other factors that would make exercise of the renewal option reasonably certain. Analysis: The lease term is 12 months or less (i.e., nine months). Therefore, the lessee accounts for the lease under the short-term lease exception (i.e., it recognizes lease payments as expense on a straight-line basis over the lease term and does not recognize a lease liability or right-of-use asset on its balance sheet, similar to an operating lease under ASC 840). 4.2 Operating leases Initial measurement Leases Lessee Initial Measurement At the commencement date, a lessee shall measure both of the following: a. The lease liability at the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement (as described in paragraphs through 30-4) b. The right-of-use asset as described in paragraph At the commencement date, the cost of the right-of-use asset shall consist of all of the following: a. The amount of the initial measurement of the lease liability b. Any lease payments made to the lessor at or before the commencement date, minus any lease incentives received c. Any initial direct costs incurred by the lessee (as described in paragraphs through 30-10). 71 Technical Line A closer look at the new leases standard 31 March 2016

72 Lease liabilities At the commencement date, a lessee initially measures the lease liability at the present value of the lease payments to be made over the lease term. Lessees apply the concepts previously described in chapter 1, Scope and scope exceptions, and chapter 2, Key concepts, to identify the lease components and to determine the lease term, lease payments and discount rate as of the commencement date of the lease Right-of-use assets A lessee initially measures the right-of-use asset at cost, which consists of all of the following: The amount of the initial measurement of the lease liability Any lease payments made to the lessor at or before the commencement date, less any lease incentives received (refer to section , Lease incentives) Any initial direct costs incurred by the lessee (refer to section 2.6, Initial direct costs) Subsequent measurement Leases Lessee Subsequent Measurement After the commencement date, for an operating lease, a lessee shall measure both of the following: a. The lease liability at the present value of the lease payments not yet paid discounted using the discount rate for the lease established at the commencement date (unless the rate has been updated after the commencement date in accordance with paragraph , in which case that updated rate shall be used) b. The right-of-use asset at the amount of the lease liability, adjusted for the following, unless the right-of-use asset has been previously impaired, in which case the right-of-use asset is measured in accordance with paragraph after the impairment: 1. Prepaid or accrued lease payments 2. The remaining balance of any lease incentives received, which is the amount of the gross lease incentives received net of amounts recognized previously as part of the single lease cost described in paragraph (a) 3. Unamortized initial direct costs 4. Impairment of the right-of-use asset. Recognition After the commencement date, a lessee shall recognize all of the following in profit or loss, unless the costs are included in the carrying amount of another asset in accordance with other Topics: a. A single lease cost, calculated so that the remaining cost of the lease (as described in paragraph ) is allocated over the remaining lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset (see paragraph ), unless the right-of-use asset has been impaired in accordance with paragraph , in which case the single lease cost is calculated in accordance with paragraph Technical Line A closer look at the new leases standard 31 March 2016

73 b. Variable lease payments not included in the lease liability in the period in which the obligation for those payments is incurred (see paragraphs through 55-2) c. Any impairment of the right-of-use asset determined in accordance with paragraph Throughout the lease term, the remaining cost of an operating lease for which the right-of-use asset has not been impaired consists of the following: a. The total lease payments (including those paid and those not yet paid), reflecting any adjustment to that total amount resulting from either a remeasurement in accordance with paragraphs through 35-5 or a lease modification; plus b. The total initial direct costs attributable to the lease; minus c. The periodic lease cost recognized in prior periods. Implementation Guidance and Illustrations A lessee should recognize costs from variable lease payments (in annual periods as well as in interim periods) before the achievement of the specified target that triggers the variable lease payments, provided the achievement of that target is considered probable Variable lease costs recognized in accordance with paragraph should be reversed at such time that it is probable that the specified target will not be met Lease liabilities After lease commencement, a lessee measures the lease liability for an operating lease at the present value of the remaining lease payments using the discount rate determined at lease commencement, as long as the discount rate hasn t been updated as a result of a reassessment event. Refer to section 2.5.3, Reassessment of the discount rate Right-of-use assets A lessee subsequently measures the right-of-use asset for an operating lease at the amount of the remeasured lease liability (i.e., the present value of the remaining lease payments), adjusted for the remaining balance of any lease incentives received, any cumulative prepaid or accrued rent if the lease payments are uneven throughout the lease term and any unamortized initial direct costs. If the right-of-use asset becomes impaired, refer to section 4.2.3, Expense recognition. The FASB indicated in the Basis for Conclusions (BC 253) that the carrying amount of the right-of-use asset for an operating lease is intended to approximate the present value of the remaining benefits to the lessee at each measurement date. Therefore, the subsequent measurement of the right-of-use asset reflects the subsequent measurement of the lease liability (i.e., the present value of the remaining lease payments), adjusted for the effect of uneven lease payments. As a result, the carrying amount of the right-of-use asset for an operating lease decreases when lease payments are made (i.e., two otherwise identical operating leases with different payment streams have different right-of-use asset balances throughout the lease term). How we see it Absent an impairment, ASC 842 requires the right-of-use asset for an operating lease to be subsequently measured using the lease liability balance, adjusted for the effect of uneven lease payments. Therefore, the right-of-use asset is effectively a plug necessary to achieve straight-line expense recognition for operating leases. 73 Technical Line A closer look at the new leases standard 31 March 2016

74 4.2.3 Expense recognition Operating lease expense is made up of the following: A single lease cost Variable lease payments that are not included in the lease liability (i.e., variable lease payments that do not depend on an index or rate) Changes to variable lease payments that depend on an index or rate Impairment of the right-of-use asset (see section 4.2.5, Impairment of right-of-use assets) Single lease cost After lease commencement, a lessee recognizes a single lease cost for an operating lease on a straight-line basis, similar to the accounting for an operating lease under ASC 840. This is consistent with the concept of the lessee paying to use the asset during the lease term rather than paying to finance the acquisition of the underlying asset in a finance lease. The single lease cost for an operating lease differs from the cost in a finance lease (i.e., a lessee recognizes interest on the finance lease liability and amortization on the finance lease right-of-use asset separately). Operating leases generally have a straight-line expense recognition pattern. Absent an impairment of the right-of-use asset, the single lease cost is calculated so that the remaining cost of the lease is allocated over the remaining lease term on straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the right to use the underlying asset. The remaining cost of the lease is calculated as: Total lease payments (including those previously paid and not yet paid) Plus total lessee initial direct costs (attributable to the lease) Minus the periodic lease cost recognized in prior periods Total lease payments are adjusted to reflect changes that arise from a lease modification (i.e., a change to the terms and conditions of the contract that results in a change in the scope of or consideration for the lease) or the remeasurement of the lease liability not recognized in profit or loss at the date of remeasurement (e.g., the present value of the additional lease payments a lessee is obligated to pay if it exercises a renewal option that it originally was not reasonably certain to exercise). Refer to section 4.4, Remeasurement of the lease liabilities and right-of-use assets. Variable lease payments After the commencement date, lessees also recognize in expense any variable lease payments not included in the operating lease liability. Variable lease payments are recognized in the period in which the achievement of the specified target that triggers the variable lease payments becomes probable. Any recognized variable lease costs are reversed when it is probable that the specified target will no longer be met. Refer to section 2.4.7, Amounts not included in lease payments, for a discussion of variable leases payments that do not depend on an index or rate. Impairment of the right-of-use asset If a lessee determines that a right-of use asset is impaired, it recognizes an impairment loss and measures the right-of-use asset at its carrying amount immediately after the impairment. Following an impairment, the single lease cost is calculated in the manner described in section 4.2.5, Impairment of right-of-use assets. 74 Technical Line A closer look at the new leases standard 31 March 2016

75 4.2.4 Example lessee accounting for an operating lease Illustration 10 Lessee accounting for an operating lease Entity L (lessee) enters into a three-year lease of office space and concludes that the agreement is an operating lease. Entity L agrees to pay the following annual payments at the end of each year: $10,000 in Year 1, $12,000 in Year 2 and $14,000 in Year 3. For simplicity, there are no purchase options, payments to the lessor before the lease commencement date, lease incentives from the lessor or initial direct costs. The initial measurement of the right-of-use asset and lease liability is $33,000 using a discount rate of 4.235%. Entity L uses its incremental borrowing rate because the rate implicit in the lease cannot be readily determined. Entity L calculates that the annual straight-line lease expense is $12,000 per year [($10,000 + $12,000 + $14,000) 3]. Analysis: At lease commencement Entity L would recognize the right-of-use asset and lease liability: Right-of-use asset $ 33,000 Lease liability $ 33,000 To initially recognize the right-of-use asset and lease liability The following journal entries would be recorded in Year 1: Lease expense $ 12,000 Right-of-use asset $ 2,000 Cash $ 10,000 Lease liability $ 8,602 Right-of-use asset $ 8,602 To record lease expense and adjust the right-of-use asset for the difference between cash paid and straight-line lease expense (i.e., accrued rent). To adjust the lease liability to the present value of the remaining lease payments with an offset to the right-of-use asset. The adjustment of $8,602 is calculated as the initially recognized lease liability ($33,000) less the present value of remaining lease payments ($24,398) at the end of Year 1. A summary of the lease contract s accounting (assuming no changes due to reassessment, lease modification or impairment) is as follows: Initial Year 1 Year 2 Year 3 Cash lease payments: $ 10,000 $ 12,000 $ 14,000 Income statement: Periodic lease expense (straight-line) 12,000 12,000 12,000 Prepaid (accrued) rent for period $ (2,000) $ $ 2,000 Balance sheet: Lease liability $ (33,000) $ (24,398) $ (13,431) $ Right-of-use asset Lease liability $ 33,000 $ 24,398 $ 13,431 $ Adjust: prepaid/(accrued) rent (cumulative) (2,000) (2,000) $ 33,000 $ 22,398 $ 11,431 $ Immaterial differences may arise in the re-computation of amounts in the example above due to rounding. Refer to section 4.3.4, Example lessee accounting for a finance lease, for a table that illustrates the similarities and differences in the accounting for an operating lease and a finance lease. 75 Technical Line A closer look at the new leases standard 31 March 2016

76 4.2.5 Impairment of right-of-use assets Leases Lessee Subsequent Measurement A lessee shall determine whether a right-of-use asset is impaired and shall recognize any impairment loss in accordance with Section on impairment or disposal of long-lived assets If a right-of-use asset is impaired in accordance with paragraph , after the impairment, it shall be measured at its carrying amount immediately after the impairment less any accumulated amortization. A lessee shall amortize, in accordance with paragraph (for an operating lease) or paragraph (for a finance lease), the right-of-use asset from the date of the impairment to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term. Recognition Lessees right-of-use assets for both operating and finance leases are subject to the existing impairment guidance in ASC After a right-of-use asset has been impaired in accordance with paragraph , the single lease cost described in paragraph (a) shall be calculated as the sum of the following: a. Amortization of the remaining balance of the right-of-use asset after the impairment on a straight-line basis, unless another systematic basis is more representative of the pattern in which the lessee expects to consume the remaining economic benefits from its right to use the underlying asset b. Accretion of the lease liability, determined for each remaining period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the liability. Lessees right-of-use assets, for both operating and finance leases (refer to section 4.3, Finance leases), are subject to existing impairment guidance in ASC 360, Property, Plant, and Equipment. The FASB indicated in the Basis for Conclusions (BC 255) that the impairment model in ASC 360 is appropriate to apply to a lessee s right-of-use assets because the right-of-use asset is a long-lived nonfinancial asset and should be accounted for the same way as an entity s other long-lived nonfinancial assets. This treatment is intended to benefit users of the financial statements by giving them comparable information about all of an entity s long-lived nonfinancial assets. ASC 360 requires an analysis of impairment indicators at each reporting period. If any indicators are present, a recoverability test using undiscounted cash flows is performed. If the right-of-use asset fails the recoverability test, ASC 360 requires a fair value test. Under ASC 842, if an impairment loss is recognized, the adjusted carrying amount of a right-of-use asset would be its new accounting basis. Consistent with ASC 360, the impairment test for right-of-use assets is often performed at an asset-group level with any impairment allocated among the asset group in accordance with ASC 360. The subsequent reversal of an impairment loss for an asset held and used is prohibited. 76 Technical Line A closer look at the new leases standard 31 March 2016

77 A lessee subsequently amortizes the right-of-use asset, generally on a straight-line basis, from the date of the impairment to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term. However, the amortization period is the remaining useful life of the underlying asset if the lessee is reasonably certain to exercise an option to purchase the underlying asset or if the lease transfers ownership of the underlying asset to the lessee by the end of the lease term. Following an impairment, the subsequent measurement of a right-of-use asset in an operating lease is similar to the subsequent measurement of a right-of-use asset in a finance lease. Single lease cost If a right-of-use asset has been impaired, the single lease cost is calculated as the sum of the following: Amortization of the remaining balance of the right-of-use asset after the impairment on a straight-line basis, unless another systematic basis is more representative of the pattern in which the lessee expects to consume the remaining economic benefits from its right to use the underlying asset Accretion of the lease liability, determined for each remaining period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the liability How we see it While lessees currently apply the impairment guidance to assets held under capital leases (generally finance leases under ASC 842), the analysis will be new for lessees that have operating leases today (generally operating leases under ASC 842). For leases that are not currently on the balance sheet but that will be on the balance sheet under ASC 842, the requirement to test the right-of-use asset for impairment would accelerate expense recognition if an impairment occurs. ASC 842 includes the following example of the subsequent accounting for an operating lease following an impairment of the right-of-use asset. Leases Lessee Implementation Guidance and Illustrations Example 5 Impairment of a Right-of-Use Asset in an Operating Lease Lessee enters into a 10-year lease of a nonspecialized asset. Lease payments are $10,000 per year, payable in arrears. The lease does not transfer ownership of the underlying asset or grant Lessee an option to purchase the underlying asset. At lease commencement, the remaining economic life of the underlying asset is 50 years, and the fair value of the underlying asset is $600,000. Lessee does not incur any initial direct costs as a result of the lease. Lessee s incremental borrowing rate is 7 percent, which reflects the fixed rate at which Lessee could borrow the amount of the lease payments in the same currency, for the same term, and with similar collateral as in the lease at commencement. The lease is classified as an operating lease At the commencement date, Lessee recognizes the lease liability of $70,236 (the present value of the 10 lease payments of $10,000, discounted at the rate of 7 percent). Lessee also recognizes a right-of-use asset of $70,236 (the initial measurement of the lease 77 Technical Line A closer look at the new leases standard 31 March 2016

78 liability). Lessee determines the cost of the lease to be $100,000 (the total lease payments for the lease term). The annual lease expense to be recognized is therefore $10,000 ($100, years) At the end of Year 3, when the carrying amount of the lease liability and the right-of-use asset are both $53,893, Lessee determines that the right-of-use asset is impaired in accordance with Section and recognizes an impairment loss of $35,000. The right-of-use asset is part of an asset group that Lessee tested for recoverability because of a significant adverse change in the business climate that affects Lessee s ability to derive benefit from the assets within the asset group. The portion of the total impairment loss for the asset group allocated to the right-of-use asset in accordance with paragraph is $35,000. After the impairment charge, the carrying amount of the right-of-use asset at the end of Year 3 is $18,893 ($53,893 $35,000). Because of the impairment, the total expense recognized in Year 3 is $45,000 ($10,000 in lease expense + the $35,000 impairment charge). Beginning in Year 4, and for the remainder of the lease term, the single lease cost recognized by Lessee in accordance with paragraphs (a) and will equal the sum of the following: a. Amortization of the right-of-use asset remaining after the impairment ($18,893 7 years = $2,699 per year) b. Accretion of the lease liability. For example, in Year 4, the accretion is $3,773 ($53,893 7%) and, in Year 5, the accretion is $3,337 ($47,665 7%) Consequently, at the end of Year 4, the carrying amount of the lease liability is $47,665 (that is, calculated as either the present value of the remaining lease payments, discounted at 7 percent, or the previous balance of $53,893 $10,000 Year 4 lease payment + the $3,773 accretion of the lease liability). The carrying amount of the right-of-use asset is $16,194 (the previous balance of $18,893 $2,699 amortization). Lessee measures the lease liability and the right-of-use asset in this manner throughout the remainder of the lease term. 4.3 Finance leases Initial measurement The initial measurement of the lease liabilities and right-of-use assets for finance leases is the same as for operating leases. Refer to section , Lease liabilities, on the initial measurement of lease liabilities for operating leases and section , Right-of-use assets, on the initial measurement of right-of-use assets for operating leases Subsequent measurement Leases Lessee Subsequent Measurement After the commencement date, for a finance lease, a lessee shall measure both of the following: a. The lease liability by increasing the carrying amount to reflect interest on the lease liability and reducing the carrying amount to reflect the lease payments made during the period. The lessee shall determine the interest on the lease liability in each period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the liability, taking into consideration the reassessment requirements in paragraphs through Technical Line A closer look at the new leases standard 31 March 2016

79 b. The right-of-use asset at cost less any accumulated amortization and any accumulated impairment losses, taking into consideration the reassessment requirements in paragraphs through A lessee shall recognize amortization of the right-of-use asset and interest on the lease liability for a finance lease in accordance with paragraph A lessee shall amortize the right-of-use asset on a straight-line basis, unless another systematic basis is more representative of the pattern in which the lessee expects to consume the right-of-use asset s future economic benefits. When the lease liability is remeasured and the right-of-use asset is adjusted in accordance with paragraph , amortization of the right-of-use asset shall be adjusted prospectively from the date of remeasurement A lessee shall amortize the right-of-use asset from the commencement date to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term. However, if the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee shall amortize the right-of-use asset to the end of the useful life of the underlying asset. Recognition After the commencement date, a lessee shall recognize in profit or loss, unless the costs are included in the carrying amount of another asset in accordance with other Topics: a. Amortization of the right-of-use asset and interest on the lease liability b. Variable lease payments not included in the lease liability in the period in which the obligation for those payments is incurred (see paragraphs through 55-2) c. Any impairment of the right-of-use asset determined in accordance with paragraph Implementation Guidance and Illustrations A lessee should recognize costs from variable lease payments (in annual periods as well as in interim periods) before the achievement of the specified target that triggers the variable lease payments, provided the achievement of that target is considered probable Variable lease costs recognized in accordance with paragraph should be reversed at such time that it is probable that the specified target will not be met Lease liabilities The FASB indicated in the Basis for Conclusions (BC 223) that a lease liability for finance leases should be accounted for in a manner similar to other financial liabilities (i.e., on an amortized cost basis). Consequently, the lease liability for finance leases is accreted using an amount that produces a constant periodic discount rate on the remaining balance of the liability (i.e., the discount rate determined at commencement, as long as a reassessment requiring a change in the discount rate has not been triggered refer to section 2.5.3, Reassessment of the discount rate). Lease payments reduce the lease liability as they are paid. 79 Technical Line A closer look at the new leases standard 31 March 2016

80 How we see it While ASC 842 describes the subsequent measurement of a finance lease liability differently from that of an operating lease liability, from a practical perspective, we expect the lease liability balance to be the same. The difference in the expense recognition pattern of an operating lease (i.e., generally straight-line expense) and a finance lease (i.e., generally front-loaded expense) is driven by the subsequent accounting for the right-of-use asset Right-of-use assets Amortization of the right-of-use asset is recognized in a manner consistent with existing guidance for nonfinancial assets that are measured at cost. Lessees amortize the right-of-use asset on a straight-line basis, unless another systematic basis better represents the pattern in which the lessee expects to consume the right-of-use asset s future economic benefits. The right-of-use asset is amortized over the shorter of the lease term or the useful life of the right-of-use asset. However, the amortization period is the remaining useful life of the underlying asset if the lessee is reasonably certain to exercise an option to purchase the underlying asset or if the lease transfers ownership of the underlying asset to the lessee by the end of the lease term Expense recognition Lessees recognize the following items in expense for finance leases: Finance leases generally have a front-loaded expense recognition pattern. Amortization of the right-of-use asset Interest on the lease liability Variable lease payments that are not included in the lease liability (i.e., variable lease payments that do not depend on an index or rate) Changes to variable lease payments that depend on an index or rate Impairment of the right-of-use asset Amortization of the right-of-use asset and interest on the lease liability After the commencement date, a lessee recognizes amortization of the right-of-use asset and separately recognizes interest on the lease liability for a finance lease. The recognition of interest and amortization expense for finance leases is consistent with a view that such leases are effectively installment purchases. That is, the lessee is paying to finance the acquisition of the underlying asset that will be consumed during the lease term. The total periodic expense (i.e., the sum of interest and amortization expense) of a finance lease is typically higher in the early periods and lower in the later periods. Because a constant interest rate is applied to the lease liability, interest expense decreases as cash payments are made during the lease term and the lease liability decreases. Therefore, more interest expense is incurred in the early periods and less in the later periods. This trend in the interest expense, combined with the straight-line amortization of the right-of-use asset, results in a front-loaded expense recognition pattern. This expense pattern is consistent with the subsequent measurement of capital leases under ASC 840. Variable lease payments After the commencement date, lessees also recognize in expense any variable lease payments not included in the finance lease liability in the period in which the achievement of the specified target that triggers the variable lease payments becomes probable. Any recognized variable lease costs are reversed when it is probable that the specified target will no longer be met. Refer to section 2.4.7, Amounts not included in lease payments, for a discussion of variable leases payments that do not depend on an index or rate. 80 Technical Line A closer look at the new leases standard 31 March 2016

81 Impairment of the right-of-use asset Lessees right-of-use assets, for both finance leases and operating leases (refer to section 4.2, Operating leases), are subject to existing impairment guidance in ASC 360. If a lessee determines that a finance lease right-of-use asset is impaired, it recognizes an impairment loss and measures the right-of-use asset at its carrying amount immediately after the impairment. A lessee subsequently amortizes, generally on a straight-line basis, the right-of-use asset from the date of the impairment to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term. However, the amortization period is the remaining useful life of the underlying asset if the lessee is reasonably certain to exercise an option to purchase the underlying asset or if the lease transfers ownership of the underlying asset to the lessee by the end of the lease term. Refer to section 4.2.5, Impairment of right-of-use assets, for additional discussion of impairment of right-of-use assets Example lessee accounting for a finance lease Illustration 11 Lessee accounting for a finance lease Entity H (lessee) enters into a three-year lease of equipment and concludes that the agreement is a finance lease because the lease term is for a major part of the remaining economic life of the underlying asset (also three years). Entity H agrees to make the following annual payments at the end of each year: $10,000 in Year 1, $12,000 in Year 2 and $14,000 in Year 3. For simplicity, there are no purchase options, payments to the lessor before the lease commencement date, lease incentives from the lessor or initial direct costs. The initial measurement of the right-of-use asset and lease liability is $33,000 (present value of lease payments using a discount rate of 4.235%). Entity H uses its incremental borrowing rate because the rate implicit in the lease cannot be readily determined. Entity H amortizes the right-of-use asset on a straight-line basis over the lease term. Analysis: At lease commencement, Entity H would recognize the right-of-use asset and lease liability: Right-of-use asset $ 33,000 Lease liability $ 33,000 To initially recognize the right-of-use asset and lease liability The following journal entries would be recorded in Year 1: Interest expense $ 1,398 Lease liability $ 1,398 To record interest expense and accrete the lease liability using the interest method ($33,000 x 4.235%) Amortization expense $ 11,000 Right-of-use asset $ 11,000 To record amortization expense on the right-of-use asset ($33,000 3 years) Lease liability $ 10,000 Cash $ 10,000 To record lease payment 81 Technical Line A closer look at the new leases standard 31 March 2016

82 A summary of the lease contract s accounting (assuming no changes due to reassessment, lease modification or impairment) is as follows: Initial Year 1 Year 2 Year 3 Cash lease payments $ 10,000 $ 12,000 $ 14,000 Lease expense recognized Interest expense $ 1,398 $ 1,033 $ 569 Amortization expense 11,000 11,000 11,000 Total periodic expense $ 12,398 $ 12,033 $ 11,569 Balance sheet Right-of-use asset $ 33,000 $ 22,000 $ 11,000 $ Lease liability $ (33,000) $ (24,398) $ (13,431) $ Immaterial differences may arise in the re-computation of amounts in the example above due to rounding. Illustration 12 Comparing the accounting for finance leases and operating leases for lessees This table illustrates the similarities and differences in accounting for finance (see Illustration 11) and operating (see Illustration 10) leases: Finance lease: Time Lease liability Right-of-use asset Initial $ 33,000 $ 33,000 Interest expense Amortization expense Total expense Year 1 $ 24,398 $ 22,000 $ 1,398 $ 11,000 $ 12,398 Year 2 $ 13,431 $ 11,000 1,033 11,000 12,033 Year 3 $ $ ,000 11,569 Operating lease: 1 Time Lease liability Cumulative prepaid or (accrued) rent 1 Right-of use asset Initial $ 33,000 $ $ 33,000 $ 3,000 $ 33,000 $ 36,000 Lease expense Year 1 $ 24,398 $ (2,000) $ 22,398 $ 12,000 Year 2 $ 13,431 $ (2,000) $ 11,431 12,000 Year 3 $ $ $ 12,000 $ 36,000 Prepaid and accrued rent amounts would not be presented separately on the balance sheet. Instead, the right-of-use asset would be presented on the balance sheet net of cumulative prepaid or accrued amounts (if any). The initial measurement of the right-of-use asset and the lease liability is the same for finance and operating leases. Also, the same total lease expense is recognized over the life of the arrangement but with different income statement classification and timing of recognition. However, a lessee generally recognizes higher periodic lease expense in the earlier periods of a finance lease than it does for an operating lease. 82 Technical Line A closer look at the new leases standard 31 March 2016

83 4.4 Remeasurement of lease liabilities and right-of-use assets Leases Lessee Subsequent Measurement After the commencement date, a lessee shall remeasure the lease liability to reflect changes to the lease payments as described in paragraphs through A lessee shall recognize the amount of the remeasurement of the lease liability as an adjustment to the right-of-use asset. However, if the carrying amount of the right-of-use asset is reduced to zero, a lessee shall recognize any remaining amount of the remeasurement in profit or loss If there is a remeasurement of the lease liability in accordance with paragraph , the lessee shall update the discount rate for the lease at the date of remeasurement on the basis of the remaining lease term and the remaining lease payments unless the remeasurement of the lease liability is the result of one of the following: a. A change in the lease term or the assessment of whether the lessee will exercise an option to purchase the underlying asset and the discount rate for the lease already reflects that the lessee has an option to extend or terminate the lease or to purchase the underlying asset. b. A change in amounts probable of being owed by the lessee under a residual value guarantee (see paragraph (c)(3)). c. A change in the lease payments resulting from the resolution of a contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based (see paragraph (b)). Leases Overall Subsequent Measurement A lessee shall remeasure the lease payments if any of the following occur: a. The lease is modified, and that modification is not accounted for as a separate contract in accordance with paragraph b. A contingency upon which some or all of the variable lease payments that will be paid over the remainder of the lease term are based is resolved such that those payments now meet the definition of lease payments. For example, an event occurs that results in variable lease payments that were linked to the performance or use of the underlying asset becoming fixed payments for the remainder of the lease term. c. There is a change in any of the following: 1. The lease term, as described in paragraph A lessee shall determine the revised lease payments on the basis of the revised lease term. 2. The assessment of whether the lessee is reasonably certain to exercise or not to exercise an option to purchase the underlying asset, as described in paragraph A lessee shall determine the revised lease payments to reflect the change in the assessment of the purchase option. 3. Amounts probable of being owed by the lessee under residual value guarantees. A lessee shall determine the revised lease payments to reflect the change in amounts probable of being owed by the lessee under residual value guarantees. 83 Technical Line A closer look at the new leases standard 31 March 2016

84 When a lessee remeasures the lease payments in accordance with paragraph , variable lease payments that depend on an index or a rate shall be measured using the index or rate at the remeasurement date. Lessees are required to remeasure finance and operating lease liabilities when there is a lease modification (i.e., a change to the terms and conditions of the contract that results in a change in the scope of or the consideration for the lease) that is not accounted for as a separate contract. Refer to section 4.5, Lease modifications. Lessees are also required to remeasure finance and operating lease liabilities when any of the following occur: A resolution of a contingency that results in some or all of the lease payments that were previously determined to be variable meeting the definition of lease payments (e.g., an event occurs that results in variable lease payments that were linked to the performance or use of the underlying asset becoming fixed payments for the remainder of the lease term) There is a change in any of the following: The lease term (refer to section 2.3.1, Lease term) The assessment of whether a lessee is reasonably certain to exercise an option to purchase the underlying asset (refer to section 2.3.2, Purchase options) The amounts it is probable the lessee will owe under residual value guarantees (refer to section 2.4.6, Amounts it is probable that a lessee will owe under residual value guarantees lessees only) In these cases, a lessee remeasures the lease liability at the reassessment date and adjusts the right-of-use asset by the change in the lease liability. However, if the right-of-use asset is reduced to zero, a lessee recognizes any remaining amount in profit or loss. The FASB indicated in the Basis for Conclusions (BC 225) that a right-of-use asset that was previously reduced to zero could be remeasured to an amount greater than zero if a reassessment of the lease term or a lessee s purchase option increases the lease liability. However, the FASB observed that a right-of-use asset would generally be measured at zero before the end of the lease term if it has been fully impaired (refer to section 4.2.5, Impairment of right-of-use assets), and it would be unlikely that a lessee would reassess the lease term upward or conclude that it is reasonably certain to exercise an option to purchase the underlying asset when it has previously impaired the right-of-use asset. The discount rate is also revised at the remeasurement date based on the remaining lease term and lease payments unless the remeasurement of the lease liability is the result of one of the following: A change in the lease term or the assessment of whether the lessee will exercise an option to purchase the underlying asset and the discount rate for the lease already reflects that the lessee has an option to extend or terminate the lease or to purchase the underlying asset A change in the amount it is probable the lessee will owe under a residual value guarantee A resolution of a contingency that results in some or all of the lease payments that were previously determined to be variable meeting the definition of lease payments Refer to Appendix B, Summary of lease reassessment and remeasurement requirements. 84 Technical Line A closer look at the new leases standard 31 March 2016

85 4.5 Lease modifications Master Glossary Lease Modification A change to the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease (for example, a change to the terms and conditions of the contract that adds or terminates the right to use one or more underlying assets or extends or shortens the contractual lease term). A lease modification is a change to the terms and conditions of a contract that results in a change in the scope of or the consideration for the lease. If a lease is modified (i.e., a change to the terms and conditions of a contract that results in a change in the scope of or consideration for the lease), the modified contract is evaluated to determine whether it is or contains a lease (refer to section 1.3, Reassessment of the contract). If a lease continues to exist, lease modification can result in: A separate contract (refer to section 4.5.1, Determining whether a lease modification is accounted for as a separate contract) A change in the accounting for the existing lease (i.e., not a separate contract refer to section 4.5.2, Lessee accounting for a modification that is not accounted for as a separate contract) Refer to Appendix C, Summary of the accounting for lease modifications lessees. The exercise of an existing purchase or renewal option or a change in the assessment of whether such options are reasonably certain to be exercised are not lease modifications but can result in the remeasurement of lease liabilities and right-of-use assets. Refer to section 4.4, Remeasurement of lease liabilities and right-of-use assets Determining whether a lease modification is accounted for as a separate contract Leases Overall Recognition An entity shall account for a modification to a contract as a separate contract (that is, separate from the original contract) when both of the following conditions are present: a. The modification grants the lessee an additional right of use not included in the original lease (for example, the right to use an additional asset). b. The lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract. For example, the standalone price for the lease of one floor of an office building in which the lessee already leases other floors in that building may be different from the standalone price of a similar floor in a different office building, because it was not necessary for a lessor to incur costs that it would have incurred for a new lessee. 85 Technical Line A closer look at the new leases standard 31 March 2016

86 A lessee accounts for a lease modification (i.e., a change to the terms and conditions of a contract that results in a change in the scope of or consideration for the lease) as a separate contract (i.e., separate from the original contract) when both of the following conditions are met: The modification grants the lessee an additional right of use that is not included in the original lease (e.g., a right to use an additional underlying asset). The lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract. If both of these conditions are met, the lease modification results in two separate contracts, the unmodified original contract and a separate contract. Lessees account for the separate contract that contains a lease in the same manner as other new leases. Refer to ASC 842 s Example 15 that illustrates this concept in section 4.5.3, Examples lessees accounting for lease modifications. If both of the conditions are not met, the modified lease is not accounted for as a separate contract. Refer to section 4.5.2, Lessee accounting for a modification that is not accounted for as a separate contract. The FASB indicated in the Basis for Conclusions (BC 176(a)) that the right to use an additional underlying asset (e.g., an additional floor of a building) will generally be a separate lease component, even if the modification granting that additional right of use does not create a separate contract. To illustrate, if an existing lease for a floor of a building is modified to include a second floor, the right to use the second floor will often be a separate lease component from the right to use the first floor, even if the second floor is not accounted for under a separate contract. Refer to section 1.4.1, Identifying and separating lease components of a contract, and ASC 842 s Example 17 that illustrates this concept in section 4.5.3, Examples lessees accounting for lease modifications. If the lease modification grants the lessee the right to use the existing leased asset for an additional period of time (i.e., a period of time not included in the original lease agreement), the modified lease is not accounted for as a separate contract. In such cases, as indicated in the Basis for Conclusions (BC 176(b)), the modification only changes an attribute of the lessee s existing right to use the underlying asset that it already controls. This is the case even if the extended term is priced at market. Refer to ASC 842 s Example 16 that illustrates this concept in section 4.5.3, Examples lessees accounting for lease modifications Lessee accounting for a modification that is not accounted for as a separate contract Master Glossary Effective Date of the Modification The date that a lease modification is approved by both the lessee and the lessor. Leases Overall Recognition If a lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph , the entity shall reassess the classification of the lease as of the effective date of the modification based on its modified terms and conditions and the facts and circumstances as of that date (for example, the fair value and remaining economic life of the underlying asset as of that date). 86 Technical Line A closer look at the new leases standard 31 March 2016

87 An entity shall account for initial direct costs, lease incentives, and any other payments made to or by the entity in connection with a modification to a lease in the same manner as those items would be accounted for in connection with a new lease A lessee shall reallocate the remaining consideration in the contract and remeasure the lease liability using a discount rate for the lease determined at the effective date of the modification if a contract modification does any of the following: a. Grants the lessee an additional right of use not included in the original contract (and that modification is not accounted for as a separate contract in accordance with paragraph ) b. Extends or reduces the term of an existing lease (for example, changes the lease term from five to eight years or vice versa), other than through the exercise of a contractual option to extend or terminate the lease (as described in paragraph ) c. Fully or partially terminates an existing lease (for example, reduces the assets subject to the lease) d. Changes the consideration in the contract only In the case of (a), (b), or (d) in paragraph , the lessee shall recognize the amount of the remeasurement of the lease liability for the modified lease as an adjustment to the corresponding right-of-use asset In the case of (c) in paragraph , the lessee shall decrease the carrying amount of the right-of-use asset on a basis proportionate to the full or partial termination of the existing lease. Any difference between the reduction in the lease liability and the proportionate reduction in the right-of-use asset shall be recognized as a gain or a loss at the effective date of the modification If a finance lease is modified and the modified lease is classified as an operating lease, any difference between the carrying amount of the right-of-use asset after recording the adjustment required by paragraph or and the carrying amount of the right-of-use asset that would result from applying the initial operating right-of-use asset measurement guidance in paragraph to the modified lease shall be accounted for in the same manner as a rent prepayment or a lease incentive. ASC 842 requires lessees to reassess lease classification at the effective date of a lease modification (i.e., the date that the lease modification is approved by both the lessee and the lessor) that is not accounted for as a separate contract. Lease classification is reassessed using the modified terms and conditions and the facts and circumstances as of that date including: The remaining economic life of the underlying asset on that date The fair value of the underlying asset on that date The discount rate for the lease on that date The remeasurement and reallocation of the remaining consideration in the contract on that date 87 Technical Line A closer look at the new leases standard 31 March 2016

88 Lessees also remeasure and reallocate the remaining consideration in the contract and remeasure the lease liability (using the discount rate determined at the effective date of the modification) if a contract modification does any of the following: Grants the lessee an additional right of use that was not included in the original contract and the modification is not accounted for as a separate contract (refer to section 4.5.1, Determining whether a modification is accounted for as a separate contract) Extends or reduces the term of an existing lease (e.g., changes the lease term from five to eight years), other than through the exercise of a contractual option to extend or terminate the lease Fully or partially terminates an existing lease (e.g., reduces the assets subject to the lease) Changes the consideration in the contract only If the lessee receives an additional right of use, extends or reduces the term of an existing lease or changes the consideration in the contract only, ASC requires the lessee to recognize the amount of the remeasurement of the lease liability as an adjustment to the corresponding right-of-use asset without affecting profit or loss. For a modification that fully or partially terminates the existing lease (e.g., reduces the square footage of leased space), ASC requires a lessee to decrease the carrying amount of the right-of-use asset in proportion to the full or partial termination of the lease. Any difference between those adjustments is recognized in profit or loss at the effective date of the modification. Refer to ASC 842 s Example 18 in section 4.5.3, Examples lessees accounting for lease modifications, for an example of the accounting for a partial termination of a lease. If a finance lease is modified and the modified lease is classified as an operating lease, any difference between the carrying amount of the right-of-use asset after recording the adjustment required by ASC or (discussed above) and the carrying amount of the right-of-use asset that would result from applying the initial operating right-of-use asset measurement guidance in ASC (i.e., the amount of the lease liability, any lease prepayments less any lease incentives received, and any initial direct costs incurred by the lessee) to the modified lease is accounted for in the same manner as a rent prepayment or a lease incentive. Lessees account for initial direct costs, lease incentives and any other payments made to or by the lessee in connection with the lease modification in the same manner as those items are accounted for in connection with a new lease. Refer to chapter 2, Key concepts Examples lessees accounting for lease modifications ASC 842 includes the following example of a lessee s accounting for a modified lease that is accounted for as a separate contract. 88 Technical Line A closer look at the new leases standard 31 March 2016

89 Leases Overall Implementation Guidance and Illustrations Example 15 Modification Accounted for as a Separate Contract Lessee enters into a 10-year lease for 10,000 square feet of office space. At the beginning of Year 6, Lessee and Lessor agree to modify the lease for the remaining 5 years to include an additional 10,000 square feet of office space in the same building. The increase in the lease payments is commensurate with the market rate at the date the modification is agreed for the additional 10,000 square feet of office space Lessee accounts for the modification as a new contract, separate from the original contract. This is because the modification grants Lessee an additional right of use as compared with the original contract, and the increase in the lease payments is commensurate with the standalone price of the additional right of use. Accordingly, from the effective date of the modification, Lessee would have 2 separate contracts, each of which contain a single lease component the original, unmodified contract for 10,000 square feet of office space and the new contract for 10,000 additional square feet of office space, respectively. Lessee would not make any adjustments to the accounting for the original lease as a result of this modification. ASC 842 includes the following example of a lessee s accounting for a modified lease that increases the term of the lease. Leases Overall Implementation Guidance and Illustrations Example 16 Modification That Increases the Lease Term Case A No Change in Lease Classification Lessee and Lessor enter into a 10-year lease for 10,000 square feet of office space in a building with a remaining economic life of 50 years. Annual payments are $100,000, paid in arrears. Lessee s incremental borrowing rate at the commencement date is 6 percent. The lease is classified as an operating lease. At the beginning of Year 6, Lessee and Lessor agree to modify the lease such that the total lease term increases from 10 years to 15 years. The annual lease payments increase to $110,000 per year for the remaining 10 years after the modification. Lessee s incremental borrowing rate is 7 percent at the date the modification is agreed to by the parties At the beginning of Year 6, Lessee s lease liability and its right-of-use asset both equal $421,236 (that is, because the lease payments are made annually in arrears and because the lease payments are even throughout the lease term, the lease liability and right-of-use asset will be equal). 89 Technical Line A closer look at the new leases standard 31 March 2016

90 The modification does not grant an additional right of use to the lessee; rather, it changes (modifies) an attribute of the right to use the 10,000 square feet of office space Lessee already controls. That is, after the modification, Lessee still controls only a single right of use transferred to Lessee at the original lease commencement date Because the modification does not grant Lessee an additional right of use, the modification cannot be a separate contract. Therefore, at the effective date of the modification, Lessee reassesses classification of the lease (which does not change in this Example see Case B [paragraphs through ] for a change in lease classification) and remeasures the lease liability on the basis of the 10-year remaining lease term, 10 remaining payments of $110,000, and its incremental borrowing rate at the effective date of the modification of 7 percent. Consequently, the modified lease liability equals $772,594. The increase to the lease liability of $351,358 is recorded as an adjustment to the right-of-use asset (that is, there is no income or loss effect from the modification). The example below assumes the same facts as Case A above except that the underlying asset is a piece of equipment with a 12-year remaining economic life at the effective date of the modification. Therefore, when the lessee reassesses classification as of the effective date of the modification, the modified lease is classified as a finance lease (i.e., lease classification changes). Leases Overall Implementation Guidance and Illustrations Example 16 Modification That Increases the Lease Term Case B Change in Lease Classification Assume the same facts as in Case A (paragraphs through ), except that the underlying asset is a piece of equipment with a 12-year remaining economic life at the effective date of the modification. Consequently, when the lessee reassesses classification of the lease in accordance with paragraph as of the effective date of the modification based on the modified rights and obligations of the parties, the lessee classifies the modified lease as a finance lease (that is, because the remaining lease term of 10 years is for a major part of the 12-year remaining economic life of the equipment) Consistent with Case A, at the effective date of the modification, the lessee remeasures its lease liability based on the 10-year remaining lease term, 10 remaining payments of $110,000, and its incremental borrowing rate of 7 percent. Consequently, the modified lease liability equals $772,594. The increase to the lease liability of $351,358 is recorded as an adjustment to the right-of-use asset (that is, there is no income or loss effect from the modification). However, different from Case A, beginning on the effective date of the modification, Lessee accounts for the 10-year modified lease as a finance lease. ASC 842 includes the following example of a lessee s accounting for a modified lease that grants an additional right of use but is not accounted for as a separate contract. 90 Technical Line A closer look at the new leases standard 31 March 2016

91 Leases Overall Implementation Guidance and Illustrations Example 17 Modification That Grants an Additional Right of Use Lessee enters into a 10-year lease for 10,000 square feet of office space. The lease payments are $100,000 per year, paid in arrears. Lessee s incremental borrowing rate at lease commencement is 6 percent. At the beginning of Year 6, Lessee and Lessor agree to modify the contract to include an additional 10,000 square feet of office space on a different floor of the building for the final 4 years of the original 10-year lease term for a total annual fixed payment of $150,000 for the 20,000 square feet The increase in the lease payments (of $50,000 per year) is at a substantial discount to the market rate at the date the modification is agreed to for leases substantially similar to that for the new 10,000 square feet of office space that cannot be attributed solely to the circumstances of the contract. Consequently, Lessee does not account for the modification as a separate contract Instead, Lessee accounts for the modified contract, which contains 2 separate lease components first, the original 10,000 square feet of office space and, second, the right to use the additional 10,000 square feet of office space for 4 years that commences 1 year after the effective date of the modification. There are no nonlease components of the modified contract. The total lease payments, after the modification, are $700,000 (1 payment of $100, payments of $150,000) Lessee allocates the lease payments in the modified contract to the 2 separate lease components on a relative standalone price basis, which, in this Example, results in the allocation of $388,889 to the original space lease and $311,111 to the additional space lease. The allocation is based on the remaining lease terms of each separate lease component (that is, 5 years for the original 10,000-square-foot lease and 4 years for the additional 10,000-square-foot lease). The remaining lease cost for each separate lease component is equal to the total payments, as allocated, which will be recognized on a straight-line basis over their respective lease terms. Lessee remeasures the lease liability for the original space lease as of the effective date of the modification the lease classification of which does not change as a result of the modification on the basis of all of the following: a. A remaining lease term of 5 years b. Annual allocated lease payments of $77,778 in Years 6 through 10 (see paragraph ) c. Lessee s incremental borrowing rate at the effective date of the modification of 7 percent The remeasured lease liability for the original space lease equals $318,904. Lessee recognizes the difference between the carrying amount of the modified lease liability and the carrying amount of the lease liability immediately before the modification of $102,332 ($421,236 $318,904) as an adjustment to the right-of-use asset. 91 Technical Line A closer look at the new leases standard 31 March 2016

92 During Year 6, Lessee recognizes lease cost of $77,778. At the end of Year 6, Lessee makes its lease payment of $100,000, of which $77,778 is allocated to the lease of the original office space and $22,222 is allocated to the lease of the additional office space as a prepayment of rent. Lessee allocates the lease payment in this manner to reflect even payments for the even use of the separate lease components over their respective lease terms At the commencement date of the separate lease component for the additional office space, which is 1 year after the effective date of the modification, Lessee measures and recognizes the lease liability at $241,896 on the basis of all of the following: a. A lease term of 4 years b. Four allocated annual payments of $72,222 ([allocated lease payments of $311,111 $22,222 rent prepayment] 4 years) c. Lessee s incremental borrowing rate at the commencement date of the separate lease component for the additional office space of 7.5 percent At the commencement date, the right-of-use asset for the additional office space lease component is recognized and measured at $264,118 (the sum of the lease liability of $241,896 and the prepaid rent asset of $22,222) During Years 7 10, Lessee recognizes lease cost of $77,778 each year for each separate lease component and allocates each $150,000 annual lease payment of $77,778 to the original office space lease and $72,222 to the additional office space lease. ASC 842 includes the following example of a lessee s accounting for a modified lease that partially terminates a lease. Leases Overall Implementation Guidance and Illustrations Example 18 Modification That Decreases the Scope of a Lease Lessee enters into a 10-year lease for 10,000 square feet of office space. The annual lease payment is initially $100,000, paid in arrears, and increases 5 percent each year during the lease term. Lessee s incremental borrowing rate at lease commencement is 6 percent. Lessee does not provide a residual value guarantee. The lease does not transfer ownership of the office space to Lessee or grant Lessee an option to purchase the space. The lease is an operating lease for all of the following reasons: a. The lease term is 10 years, while the office building has a remaining economic life of 40 years. b. The fair value of the office space is estimated to be significantly in excess of the present value of the lease payments. c. The office space is expected to have an alternative use to Lessor at the end of the lease term. 92 Technical Line A closer look at the new leases standard 31 March 2016

93 At the beginning of Year 6, Lessee and Lessor agree to modify the original lease for the remaining 5 years to reduce the lease to only 5,000 square feet of the original space and to reduce the annual lease payment to $68,000. That amount will increase 5 percent each year thereafter of the remaining lease term The classification of the lease does not change as a result of the modification. It is clear based on the terms of the modified lease that it is not a finance lease because the modification reduces both the lease term and the lease payments. Lessee remeasures the lease liability for the modified lease at the effective date of the modification on the basis of all of the following: a. A remaining lease term of 5 years b. Lease payments of $68,000 in the year of modification (Year 6), increasing by 5 percent each year thereafter c. Lessee s incremental borrowing rate at the effective date of the modification of 7 percent The remeasured lease liability equals $306,098. Case A Remeasuring the Right-of-Use Asset Based on Change in Lease Liability The difference between the premodification liability and the modified lease liability is $284,669 ($590,767 $306,098). That difference is 48.2 percent ($284,669 $590,767) of the premodification lease liability. The decrease in the lease liability reflects the early termination of the right to use 5,000 square feet of space (50 percent of the original leased space), the change in the lease payments, and the change in the discount rate Lessee decreases the carrying amount of the right-of-use asset to reflect the partial termination of the lease based on the adjustment to the carrying amount of the lease liability, with any difference recognized in profit or loss. The premodification right-of-use asset is $514,436. Therefore, at the effective date of the modification, Lessee reduces the carrying amount of the right-of-use asset by $247,888 (48.2% $514,436). Lessee recognizes the difference between the adjustment to the lease liability and the adjustment to the right-of-use asset ($284,669 $247,888 = $36,781) as a gain. Case B Remeasuring the Right-of-Use Asset Based on the Remaining Right of Use Lessee determines the proportionate decrease in the carrying amount of the right-of-use asset based on the remaining right-of-use asset (that is, 5,000 square feet corresponding to 50 percent of the original right-of-use asset) Fifty percent of the premodification right-of-use asset is $257,218 (50% x $514,436). Fifty percent of the premodification lease liability is $295,384 (50% x $590,767). Consequently, Lessee decreases the carrying amount of the right-of-use asset by $257,218 and the carrying amount of the lease liability by $295,384. At the effective date of the modification, Lessee recognizes the difference between the decrease in the lease liability and the decrease in the right-of-use asset of $38,166 ($295,384 $257,218) as a gain. 93 Technical Line A closer look at the new leases standard 31 March 2016

94 Lessee recognizes the difference between the remaining lease liability of $295,384 and the modified lease liability of $306,098 (which equals $10,714) as an adjustment to the right-of-use asset reflecting the change in the consideration paid for the lease and the revised discount rate. ASC 842 includes the following example of a lessee s accounting for a modified lease that only changes the lease payments. Leases Overall Implementation Guidance and Illustrations Example 19 Modification That Changes the Lease Payments Only Lessee enters into a 10-year lease for 10,000 square feet of office space. The lease payments are $95,000 in Year 1, paid in arrears, and increase by $1,000 every year thereafter. The original discount rate for the lease is 6 percent. The lease is an operating lease. At the beginning of Year 6, Lessee and Lessor agree to modify the original lease for the remaining 5 years to reduce the lease payments by $7,000 each year (that is, the lease payments will be $93,000 in Year 6 and will continue to increase by $1,000 every year thereafter). The modification only changes the lease payments and, therefore, cannot be accounted for as a separate contract. The classification of the lease does not change as a result of the modification Lessee remeasures the lease liability for the modified lease on the basis of all of the following: a. Remaining lease term of 5 years b. Payments of $93,000 in Year 6, increasing by $1,000 each year for the remainder of the lease term c. Lessee s incremental borrowing rate at the effective date of the modification of 7 percent The remeasured lease liability equals $388,965. Lessee recognizes the difference between the carrying amount of the modified lease liability and the lease liability immediately before the effective date of the modification of $40,206 ($429,171 premodification lease liability $388,965 modified lease liability) as a corresponding reduction to the right-of-use asset. Therefore, the adjusted right-of-use asset equals $376,465 as of the effective date of the modification. Lessee calculates its remaining lease cost as $462,500 (the sum of the total lease payments, as adjusted for the effects of the lease modification, of $960,000 reduced by the total lease cost recognized in prior periods of $497,500), which it will recognize on a straight-line basis over the remaining lease term During Year 6, Lessee recognizes lease cost of $92,500 ($462,500 remaining lease cost 5 years). As of the end of Year 6, Lessee s lease liability equals $323,193 (present value of the remaining lease payments, discounted at 7 percent), and its right-of-use asset equals $311,193 (the balance of the lease liability the remaining accrued rent balance of $12,000). Lessee recognizes additional lease cost of $92,500 each year of the remaining lease term and measures its lease liability and right-of-use asset in the same manner as at the end of Year 6 each remaining year of the lease term. The following are the balances of 94 Technical Line A closer look at the new leases standard 31 March 2016

95 the lease liability and the right-of-use asset at the end of Years 7 through 10 of the lease. Lease Liability Right-of-Use Asset Year 7 $ 251,816 $ 241,316 Year 8 $ 174,443 $ 166,443 Year 9 $ 90,654 $ 86,154 Year 10 $ $ 4.6 Other lessee matters Lessee involvement in asset construction ( build-to-suit lease transactions) Build-to-suit lease transactions involve various forms of lessee involvement in the construction of an asset for the lessee s own use. Under ASC 840, a lessee is considered the owner of an asset during the construction period if it takes on substantially all of the construction-period risks. If the lessee is considered the owner of the asset during the construction period, a deemed sale and leaseback of the asset occurs when construction of the asset is completed and the lease term begins. ASC 842 significantly changes the guidance on lessee involvement in asset construction. The guidance in ASC 842 focuses on whether the lessee controls the asset being constructed rather than whether the lessee takes on risks during the construction period. Under ASC 842, if the lessee controls the asset during construction, the asset is capitalized as construction-in-progress and is subject to the sale and leaseback guidance at the end of construction. Refer to section 7.4.1, Determining whether the lessee controls the underlying asset being constructed, and section 7.1, Determining whether the transfer of an asset is a sale, on the accounting for sale and leaseback transactions Amortization of leasehold improvements Leases Lessee Subsequent Measurement Leasehold improvements shall be amortized over the shorter of the useful life of those leasehold improvements and the remaining lease term, unless the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, in which case the lessee shall amortize the leasehold improvements to the end of their useful life. ASC 842 requires lessees to amortize leasehold improvements over the shorter of the following: The useful life of those leasehold improvements The remaining lease term However, if the lease transfers ownership of the underlying asset to the lessee or the lessee is reasonably certain to exercise an option to purchase the underlying asset, leasehold improvements are amortized over their useful life. 95 Technical Line A closer look at the new leases standard 31 March 2016

96 The accounting for the amortization of leasehold improvements should be consistent with the lease term Lease termination Leases Lessee Derecognition A termination of a lease before the expiration of the lease term shall be accounted for by the lessee by removing the right-of-use asset and the lease liability, with profit or loss recognized for the difference. A termination of a lease before the expiration of the lease term is accounted for by derecognizing the lease-related asset and liability. Any consideration paid or received upon termination that was not already included in the lease payments (e.g., a termination penalty that was not included in lease payments based on the lease term) is included in the gain or loss on termination of the lease Purchase of a leased asset during the lease term Leases Lessee Derecognition The termination of a lease that results from the purchase of an underlying asset by the lessee is not the type of termination of a lease contemplated by paragraph but, rather, is an integral part of the purchase of the underlying asset. If the lessee purchases the underlying asset, any difference between the purchase price and the carrying amount of the lease liability immediately before the purchase shall be recorded by the lessee as an adjustment of the carrying amount of the asset. However, this paragraph does not apply to underlying assets acquired in a business combination, which are initially measured at fair value in accordance with paragraph A lease termination does not include the exercise of a purchase option included in the terms of the lease arrangement. That is, exercising a purchase option does not affect profit or loss, regardless of whether the option was considered reasonably certain to be exercised. Rather the difference between the purchase price and the carrying amount of the lease liability is recorded as an adjustment to the carrying amount of the purchased asset. This guidance does not apply to underlying assets acquired in a business combination, which are initially measured at fair value. Refer to chapter 8, Business combinations Lease incentives not received or receivable at lease commencement ASC 842 does not address the accounting for lease incentives that are contingently receivable by the lessee at the lease commencement date (i.e., lease incentives that are not received or receivable until the occurrence of an event subsequent to lease commencement). Examples include reimbursements for moving costs or leasehold improvements that become receivable by the lessee when the lessee incurs these costs. 96 Technical Line A closer look at the new leases standard 31 March 2016

97 4.6.6 Leases denominated in a foreign currency Leases Lessee Implementation Guidance and Illustrations The right-of-use asset is a nonmonetary asset while the lease liability is a monetary liability. Therefore, in accordance with Subtopic on foreign currency matters, when accounting for a lease that is denominated in a foreign currency, if remeasurement into the lessee s functional currency is required, the lease liability is remeasured using the current exchange rate, while the right-of-use asset is remeasured using the exchange rate as of the commencement date. Lessees apply ASC 830, Foreign Currency Matters, to leases denominated in a foreign currency. As they do for other monetary liabilities, lessees remeasure a foreign currency-denominated lease liability using the exchange rate at each reporting date. Any changes to the lease liability due to exchange rate changes are recognized in profit or loss. Because the right-of-use asset is a nonmonetary asset measured at historical cost, it is not affected by changes in the exchange rate. Therefore, the subsequent measurement of the right-of-use asset will not equal the lease liability for operating leases denominated in a foreign currency. The FASB acknowledged in the Basis for Conclusions (BC 247) that this approach could result in volatility in profit or loss from the recognition of foreign currency exchange gains or losses but it will be clear to users of financial statements that the gains or losses result solely from changes in exchange rates Portfolio approach ASC 842 applies to individual leases. However, entities that have a large number of leases of similar assets (e.g., leases of a fleet of similar rail cars) may face practical challenges in applying the leases model on a lease by lease basis. The FASB acknowledged these concerns and said in the Basis for Conclusions (BC 120) that an entity can use a portfolio approach when the entity reasonably expects that the application of the leases model to the portfolio would not differ materially from the application of the leases model to the individual leases in that portfolio. For example, applying a portfolio approach to four-year leases of new automobiles of the same make and model, entered into in the same month with the same terms and conditions, may not differ materially from applying ASC 842 to the individual leases in the portfolio. ASC 842 does not define reasonably expects and materially. The FASB also said in the Basis for Conclusions (BC 120) that an entity would need to apply judgment in selecting the size and composition of the portfolio and it did not intend for an entity to quantitatively evaluate each outcome but, instead, that the entity should be able to take a reasonable approach to determine the portfolios that would be appropriate for its types of leases. The FASB also said in the Basis for Conclusions (BC 121) that the cost relief offered by applying the leases guidance at a portfolio level need not be limited to simply grouping contracts together. The portfolio approach could also be applied to other aspects of the leases guidance for which lessees need to make judgments and estimates, such as determining the discount rate and determining and reassessing the lease term. 97 Technical Line A closer look at the new leases standard 31 March 2016

98 ASC 842 provides the following implementation guidance for applying the portfolio approach to establish the discount rate for the lease. Leases Lessee Implementation Guidance and Illustrations Example 2 Portfolio Approach to Establishing the Discount Rate for the Lease Lessee, a public entity, is the parent of several consolidated subsidiaries. During the current period, 2 subsidiaries entered into a total of 400 individual leases of large computer servers, each with terms ranging between 4 and 5 years and annual payments ranging between $60,000 and $100,000, depending on the hardware capacity of the servers. In aggregate, total lease payments for these leases amount to $30 million The individual lease contracts do not provide information about the rate implicit in the lease. Lessee is BBB credit rated and actively raises debt in the corporate bond market. Both subsidiaries are unrated and do not actively engage in treasury operations in their respective markets. On the basis of its credit rating and the collateral represented by the leased servers, Lessee s incremental borrowing rate on $60,000 through $100,000 (the range of lease payments on each of the 400 leases) would be approximately 4 percent. Lessee notes that 5-year zero-coupon U.S. Treasury instruments are currently yielding 1.7 percent (a risk-free rate). Because Lessee conducts its treasury operations centrally (that is, at the consolidated group level), it is reasonably assumed that consideration of the group credit standing factored into how each lease was priced Lessee may determine the discount rate for the lease for the 400 individual leases entered into on different dates throughout the current period by using a portfolio approach. That is, Lessee can apply a single discount rate to the portfolio of new leases. This is because during the period, the new leases are all of similar terms (four to five years), and Lessee s credit rating and the interest rate environment are stable. Because the pricing of the lease is influenced by the credit standing and profile of Lessee rather than the subsidiaries (that is, because Lessee conducts treasury operations for the consolidated group), Lessee concludes that its incremental borrowing rate of 4 percent is an appropriate discount rate for each of the 400 leases entered into by Lessee s 2 subsidiaries during the period. Because Lessee is a public entity, it is not permitted to use a risk-free discount rate Income tax accounting ASC 842 also affects lessees accounting for income taxes. For lessees, ASC 842 requires recognition of lease-related assets and liabilities that are not on the balance sheet under ASC 840 (i.e., amounts related to leases that are operating leases under ASC 840) and could change the measurement of other lease-related assets and liabilities. These changes affect certain aspects of accounting for income taxes such as the following: Recognition and measurement of deferred tax assets and liabilities Assessment of the recoverability of deferred tax assets (i.e., the need for and measurement of a valuation allowance) Refer to our Financial reporting developments publication, Income taxes. 98 Technical Line A closer look at the new leases standard 31 March 2016

99 4.7 Presentation Leases Lessee Other Presentation Matters Statement of Financial Position A lessee shall either present in the statement of financial position or disclose in the notes all of the following: a. Finance lease right-of-use assets and operating lease right-of-use assets separately from each other and from other assets b. Finance lease liabilities and operating lease liabilities separately from each other and from other liabilities. Right-of-use assets and lease liabilities shall be subject to the same considerations as other nonfinancial assets and financial liabilities in classifying them as current and noncurrent in classified statements of financial position If a lessee does not present finance lease and operating lease right-of- use assets and lease liabilities separately in the statement of financial position, the lessee shall disclose which line items in the statement of financial position include those right-of-use assets and lease liabilities In the statement of financial position, a lessee is prohibited from presenting both of the following: a. Finance lease right-of-use assets in the same line item as operating lease right-of-use assets b. Finance lease liabilities in the same line item as operating lease liabilities. Statement of Comprehensive Income In the statement of comprehensive income, a lessee shall present both of the following: a. For finance leases, the interest expense on the lease liability and amortization of the right-of-use asset are not required to be presented as separate line items and shall be presented in a manner consistent with how the entity presents other interest expense and depreciation or amortization of similar assets, respectively b. For operating leases, lease expense shall be included in the lessee s income from continuing operations. Statement of Cash Flows In the statement of cash flows, a lessee shall classify all of the following: a. Repayments of the principal portion of the lease liability arising from finance leases within financing activities b. Interest on the lease liability arising from finance leases in accordance with the requirements relating to interest paid in Topic 230 on cash flows 99 Technical Line A closer look at the new leases standard 31 March 2016

100 c. Payments arising from operating leases within operating activities, except to the extent that those payments represent costs to bring another asset to the condition and location necessary for its intended use, which should be classified within investing activities d. Variable lease payments and short-term lease payments not included in the lease liability within operating activities. While ASC 842 changes balance sheet presentation for lessees, the income statement and statement of cash flows presentation requirements for finance leases and operating leases are similar to the current requirements for capital and operating leases, respectively. Right-of-use assets and lease liabilities are subject to the same considerations as other nonfinancial assets and financial liabilities in classifying them as current and noncurrent in classified statements of financial position. The following table summarizes how lease-related amounts and activities are presented in lessees financial statements. Financial statement Balance sheet Lessee presentation Finance leases: A lessee presents either in the statement of financial position or discloses in the notes all of the following: Right-of-use assets presented either: Separately from other assets (e.g., owned assets) and separately from operating lease right-of-use assets Together with other assets and separate from operating lease right-of-use assets, with disclosures of the balance sheet line items that include finance lease right-of-use assets and their amounts Lease liabilities presented either: Separately from other liabilities and separately from operating lease liabilities Together with other liabilities and separate from operating lease liabilities, with disclosure of the balance sheet line items that include finance lease liabilities and their amounts Operating leases: A lessee presents either in the statement of financial position or discloses in the notes all of the following: Right-of-use assets presented either: Separately from other assets (e.g., owned assets) and separately from finance lease right-of-use assets Together with other assets and separate from finance lease right-of-use assets, with disclosures of the balance sheet line items that include operating lease right-of-use assets and their amounts Lease liabilities presented either: Separately from other liabilities and separately from finance lease liabilities Together with other liabilities and separate from finance lease liabilities, with disclosure of the balance sheet line items that include operating lease liabilities and their amounts 100 Technical Line A closer look at the new leases standard 31 March 2016

101 Financial statement Lessee presentation New disclosures are required about judgments made and assumptions used to account for leases. Income statement Statement of cash flows Finance leases: Lease-related amortization and lease-related interest expense are not required to be presented as separate line items and should be presented in a manner consistent with how the entity presents depreciation and amortization of similar assets and other interest expense. However, lease-related amortization and lease-related interest expense cannot be combined in the same line item. Operating leases: Lease expense is included in income from continuing operations. Finance leases: Cash payments for the principal portion of the lease liability are presented within financing activities and cash payments for the interest portion are presented in accordance with ASC 230, Statement of Cash Flows. Operating leases: Cash payments for lease payments are presented within operating activities, except for payments that represent costs to bring another asset to the condition and location necessary for its intended use, which are presented within investing activities. Both types of leases: Lease payments for short-term leases not recognized on the balance sheet and variable lease payments (not included in the lease liability) are presented within operating activities. Noncash activity (e.g., the initial recognition of the lease at commencement) is disclosed as a supplemental noncash item. 4.8 Disclosure The objective of lessee disclosures is to enable financial statement users to assess the amount, timing and uncertainty of cash flows arising from leases. ASC 842 requires a lessee to disclose quantitative and qualitative information about its leases, the significant judgments and assumptions made in applying ASC 842 and the amounts recognized in the financial statements related to those leases. ASC 842 does not require a specific format for lessees quantitative disclosures but includes an example in a tabular format. Lessees may need to exercise judgment to determine the appropriate level at which to aggregate, or disaggregate, disclosures so that meaningful information is not be obscured by insignificant details or by groupings of items with different characteristics. The disclosure requirements apply to all entities. 101 Technical Line A closer look at the new leases standard 31 March 2016

102 ASC 842 includes the following disclosure requirements for lessees. Leases Lessee Disclosure The objective of the disclosure requirements is to enable users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. To achieve that objective, a lessee shall disclose qualitative and quantitative information about all of the following: a. Its leases (as described in paragraphs (a) through (b) and through 50-8) b. The significant judgments made in applying the requirements in this Topic to those leases (as described in paragraph (c)) c. The amounts recognized in the financial statements relating to those leases (as described in paragraphs and ) A lessee shall consider the level of detail necessary to satisfy the disclosure objective and how much emphasis to place on each of the various requirements. A lessee shall aggregate or disaggregate disclosures so that useful information is not obscured by including a large amount of insignificant detail or by aggregating items that have different characteristics A lessee shall disclose all of the following: a. Information about the nature of its leases, including: 1. A general description of those leases. 2. The basis and terms and conditions on which variable lease payments are determined. 3. The existence and terms and conditions of options to extend or terminate the lease. A lessee should provide narrative disclosure about the options that are recognized as part of its right-of-use assets and lease liabilities and those that are not. 4. The existence and terms and conditions of residual value guarantees provided by the lessee. 5. The restrictions or covenants imposed by leases, for example, those relating to dividends or incurring additional financial obligations. A lessee should identify the information relating to subleases included in the disclosures provided in (1) through (5), as applicable. b. Information about leases that have not yet commenced but that create significant rights and obligations for the lessee, including the nature of any involvement with the construction or design of the underlying asset. 102 Technical Line A closer look at the new leases standard 31 March 2016

103 c. Information about significant assumptions and judgments made in applying the requirements of this Topic, which may include the following: 1. The determination of whether a contract contains a lease (as described in paragraphs through 15-27) 2. The allocation of the consideration in a contract between lease and nonlease components (as described in paragraphs through 15-32) 3. The determination of the discount rate for the lease (as described in paragraphs through 30-4) For each period presented in the financial statements, a lessee shall disclose the following amounts relating to a lessee s total lease cost, which includes both amounts recognized in profit or loss during the period and any amounts capitalized as part of the cost of another asset in accordance with other Topics, and the cash flows arising from lease transactions: a. Finance lease cost, segregated between the amortization of the right-of-use assets and interest on the lease liabilities. b. Operating lease cost determined in accordance with paragraphs (a) and c. Short-term lease cost, excluding expenses relating to leases with a lease term of one month or less, determined in accordance with paragraph d. Variable lease cost determined in accordance with paragraphs (b) and (b). e. Sublease income, disclosed on a gross basis, separate from the finance or operating lease expense. f. Net gain or loss recognized from sale and leaseback transactions in accordance with paragraph g. Amounts segregated between those for finance and operating leases for the following items: 1. Cash paid for amounts included in the measurement of lease liabilities, segregated between operating and financing cash flows 2. Supplemental noncash information on lease liabilities arising from obtaining right-of-use assets 3. Weighted-average remaining lease term 4. Weighted-average discount rate. 103 Technical Line A closer look at the new leases standard 31 March 2016

104 A lessee shall disclose a maturity analysis of its finance lease liabilities and its operating lease liabilities separately, showing the undiscounted cash flows on an annual basis for a minimum of each of the first five years and a total of the amounts for the remaining years. A lessee shall disclose a reconciliation of the undiscounted cash flows to the finance lease liabilities and operating lease liabilities recognized in the statement of financial position A lessee shall disclose lease transactions between related parties in accordance with paragraphs through A lessee that accounts for short-term leases in accordance with paragraph shall disclose that fact. If the short-term lease expense for the period does not reasonably reflect the lessee s short-term lease commitments, a lessee shall disclose that fact and the amount of its short-term lease commitments A lessee that elects the practical expedient on not separating lease components from nonlease components in paragraph shall disclose its accounting policy election and which class or classes of underlying assets it has elected to apply the practical expedient. 104 Technical Line A closer look at the new leases standard 31 March 2016

105 5 Lessor accounting The FASB indicated in the Basis for Conclusions (BC 90) that ASC 840 s lessor accounting model did not need comprehensive improvements, and the costs of making changes would outweigh the benefits. Therefore, ASC 842 retains many aspects of the lessor accounting model under ASC 840. However, ASC 842 modifies ASC 840 s lease classification test for lessors. Refer to section 3.2, Criteria for lease classification lessors, for a discussion of the lessor classification test under ASC 842 and section 3.5, Comparison of the lease classification tests in ASC 842 and ASC 840, for a summary of classification changes from ASC 840. The new guidance also modifies the accounting for sales-type and direct financing leases. Sales-type leases ASC 842 retains many aspects of today s lessor accounting model but modifies the lease classification test and the accounting for sales-type and direct financing leases. Under ASC 842, there is no requirement for a sales-type lease to have selling profit or loss as there is under ASC 840. Additionally, a lessor does not assess the collectibility of lease payments and any residual value guarantee provided by the lessee for purposes of evaluating whether a lease is classified as a sales-type lease under ASC 842. However, a lessor has to assess the collectibility of these amounts when accounting for a sales-type lease. Specifically, if at lease commencement, the collectibility of lease payments and any residual value guarantee provided by the lessee is not probable, the lessor does not derecognize the underlying asset and recognizes lease payments received, including variable lease payments that do not depend on an index or rate, as a deposit liability (i.e., selling profit and lease income are deferred). Refer to section 5.2, Sales-type leases, for further discussion of the accounting for sales-type leases under ASC 842. Direct financing leases In another change from ASC 840, a direct financing lease could have selling profit or loss. However, selling profit on a direct financing lease is deferred at lease commencement while selling loss is always recognized at lease commencement. As noted in section 3.2, Criteria for lease classification lessors, the lease classification test is designed so that a lease can be classified as a direct financing lease only when the lessor obtains a residual value guarantee from an unrelated third party other than the lessee and that guarantee is sufficient to satisfy the substantially all criterion discussed in section 3.2, Criteria for lease classification lessors. Although a residual value guarantee from an unrelated third party other than the lessee can exist in a sales-type lease or an operating lease, a lease without a residual value guarantee from an unrelated third party other than the lessee must be classified as either a sales-type lease or an operating lease. Refer to section 5.3, Direct financing leases, for further discussion of the accounting for direct financing leases under ASC 842. Leveraged leases ASC 842 eliminates leveraged lease accounting for new leases and existing leases modified on or after the standard s effective date. Refer to section 5.7.5, Leveraged leases. 5.1 Lessor accounting concepts At lease commencement, lessors apply the key concepts described in chapter 2, Key concepts, such as determining the initial direct costs, lease term, lease payments, fair value of the underlying asset and the rate implicit in the lease. Lessors also apply the following lessor accounting concepts to recognize and measure their leases. 105 Technical Line A closer look at the new leases standard 31 March 2016

106 5.1.1 Net investment in the lease Master Glossary Net investment in the lease For a sales-type lease, the sum of the lease receivable and the unguaranteed residual asset. For a direct financing lease, the sum of the lease receivable and the unguaranteed residual asset, net of any deferred selling profit. Lease Receivable A lessor s right to receive lease payments arising from a sales-type lease or a direct financing lease plus any amount that a lessor expects to derive from the underlying asset following the end of the lease term to the extent that it is guaranteed by the lessee or any other third party unrelated to the lessor, measured on a discounted basis. Unguaranteed residual asset The amount that a lessor expects to derive from the underlying asset following the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, measured on a discounted basis. A lessor s net investment in a sales-type or a direct financing lease consists of the following: Lease receivable The lease receivable is (1) the lessor s right to receive lease payments (refer to section 2.4, Lease payments) and (2) any amount a lessor expects to derive from the underlying asset at the end of the lease term that is guaranteed by the lessee or any other third party unrelated to the lessor (i.e., the guaranteed residual asset), both discounted using the rate implicit in the lease. Unguaranteed residual asset The unguaranteed residual asset is any amount the lessor expects to derive from the underlying asset at the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, discounted using the rate implicit in the lease. Deferred selling profit (direct financing leases only) Any selling profit (refer to section 5.1.2, Selling profit or selling loss) for a direct financing lease is deferred and reduces the lessor s net investment in the lease Selling profit or selling loss Master Glossary Selling Profit or Selling Loss At the commencement date, selling profit or selling loss equals: a. The fair value of the underlying asset or the sum of (1) the lease receivable and (2) any lease payments prepaid by the lessee, if lower; minus b. The carrying amount of the underlying asset net of any unguaranteed residual asset; minus c. Any deferred initial direct costs of the lessor. 106 Technical Line A closer look at the new leases standard 31 March 2016

107 Leases that give rise to selling profit or selling loss normally result when the lessor uses leasing as a means of marketing its products or disposing of an asset. Under ASC 842, selling profit or selling loss is calculated as follows: The fair value (as defined in ASC 820, refer to section 2.8, Fair value) of the underlying asset or the sum of (1) the lease receivable and (2) any prepaid lease payments from the lessee (net of any lease incentives paid to the lessee), if lower Minus the carrying amount of the underlying asset, net of any unguaranteed residual asset Minus any deferred initial direct costs of the lessor The calculation of selling profit is based on the lower of (1) the fair value of the underlying asset and (2) the sum of the lease receivable and any prepaid lease payments from the lessee (net of any lease incentives paid to the lessee) because lease revenue in a sales-type lease is limited to the sum of the receivable and any prepayments received (net of incentives paid to the lessee). Refer to section 5.8, Presentation. Selling profit sales-type leases ASC 842 requires a lessor to recognize any selling profit on a sales-type lease at lease commencement, assuming that collectibility of both lease payments and any residual value guarantee provided by the lessee is probable (refer to section , Collectibility is probable at lease commencement). When collectibility of lease payments and any residual value guarantee provided by the lessee is not probable, the underlying asset is not derecognized and no selling profit is recognized (refer to section , Collectibility is not probable at lease commencement). The FASB included this guidance for the recognition of initial selling profit for sales-type leases to better align the leases guidance with the principles in ASC 606. The FASB indicated in the Basis for Conclusions (BC 93) that even though a sales-type lease is not necessarily identical to a sale, the transactions are economically similar (e.g., because sales-type lessors often use leasing as an alternative means to sell their assets and have no intention of reusing or re-leasing assets leased under a sales-type lease). Selling profit direct financing leases As noted above, the lease classification test is designed so that a lease can be a direct financing lease only when the lessor obtains a residual value guarantee from an unrelated third party other than the lessee and that guarantee is sufficient to satisfy (when added to lease payments) the substantially all criterion discussed in section 3.2, Criteria for lease classification lessors. Although a residual value guarantee from an unrelated third party other than the lessee can exist in a sales-type lease or an operating lease, a lease without a residual value guarantee from an unrelated third party other than the lessee must be classified as either a sales-type lease or an operating lease. ASC 842 requires a lessor to defer any selling profit on a direct financing lease at lease commencement and amortize it over the lease term in a manner that, when combined with the interest income on the lease receivable and the unguaranteed residual asset, produces a constant periodic discount rate on the remaining balance of the net investment in the lease. Refer to section 5.3.2, Subsequent measurement, for a discussion of the subsequent measurement for direct financing leases. 107 Technical Line A closer look at the new leases standard 31 March 2016

108 Selling loss Any selling loss on a sales-type lease or direct financing lease is recognized immediately at lease commencement, but a loss may indicate that the underlying asset was impaired prior to lease commencement. How we see it Under ASC 840, leases of real estate often do not result in profit recognition (e.g., when there is no transfer of title to the real estate, the lease is often classified as an operating or a direct financing lease). Under ASC 842, however, a lessor could classify certain leases of real estate (including a lease of a portion of real estate) as sale-type leases, with initial selling profit. This is a significant change from current practice. A lessor that concludes, in accordance with ASC , that it is not practicable for it to determine the fair value of an underlying asset (particularly an identified portion of an underlying asset) and does not evaluate the substantially all lease classification criterion may face practical challenges if the lease is classified as a sales-type lease based on the other applicable criteria discussed in section 3.2, Criteria for lease classification lessors. In that case, the lessor is still required to determine the fair value of the underlying asset in order to calculate selling profit or loss and to measure the net investment in the sales-type lease Collectibility Collectibility is not assessed for purposes of the sales-type lease classification test. Rather, lessors assess the collectibility of lease payments and any residual value guarantee provided by the lessee for purposes of determining initial recognition and measurement of sales-type leases. For example, if collection of lease payments and any residual value guarantee provided by the lessee is not probable (i.e., not likely to occur), the underlying asset is not derecognized and all income is deferred. Under ASC 840, this type of lease would be classified as an operating lease. Refer to section 5.2, Sales-type leases. ASC 842 requires lessors to evaluate the collectibility of lease payments and any residual value guarantee (i.e., a guarantee provided by a lessee or any other third party unrelated to the lessor) to determine lease classification for leases that would otherwise be classified as direct financing leases. That is, if collection of lease payments and any residual value guarantee is not probable (i.e., it is not likely to occur), the lease is classified as an operating lease. Refer to section 3.2, Criteria for lease classification lessors. Collectibility of lease payments must also be evaluated for operating leases to determine the income recognition pattern for those leases. Refer to section 5.4, Operating leases. 108 Technical Line A closer look at the new leases standard 31 March 2016

109 The following table summarizes how the collectibility assessment affects lease classification, recognition and measurement for lessors. Sales-type lease Direct financing lease Operating lease Classification at lease commencement Collectibility has no effect on lease classification Collectibility is probable (assuming the other classification criterion is met) direct financing lease Collectibility is not probable operating lease Not applicable operating leases are leases that do not meet the criteria to be classified as sales-type or direct financing leases (including leases that would otherwise be direct financing leases if collectibility was probable) Initial recognition and measurement at lease commencement Collectibility is probable recognize any selling profit or loss Collectibility is not probable do not derecognize the underlying asset and defer any selling profit Not applicable Not applicable Subsequent measurement Collectibility is probable at lease commencement net investment is evaluated for impairment under ASC 310, Receivables Collectibility is not probable at lease commencement refer to section , Collectibility is not probable at lease commencement Net investment evaluated for impairment under ASC 310 Collectibility is probable recognize income generally on a straight-line basis Collectibility is not probable income recognition can be no greater than lease payments and variable lease payments received 5.2 Sales-type leases Initial recognition and measurement Leases Lessor Recognition At the commencement date, a lessor shall recognize each of the following and derecognize the underlying asset in accordance with paragraph : a. A net investment in the lease, measured in accordance with paragraph b. Selling profit or selling loss arising from the lease c. Initial direct costs as an expense if, at the commencement date, the fair value of the underlying asset is different from its carrying amount. If the fair value of the underlying asset equals its carrying amount, initial direct costs (see paragraphs through 30-10) are deferred at the commencement date and included in the measurement of the net investment in the lease. The rate implicit in the lease is defined in such a way that those initial direct costs eligible for deferral are included automatically in the net investment in the lease; there is no need to add them separately. 109 Technical Line A closer look at the new leases standard 31 March 2016

110 The guidance in paragraphs through 25-2 notwithstanding, if collectibility of the lease payments, plus any amount necessary to satisfy a residual value guarantee provided by the lessee, is not probable at the commencement date, the lessor shall not derecognize the underlying asset but shall recognize lease payments received including variable lease payments as a deposit liability until the earlier of either of the following: a. Collectibility of the lease payments, plus any amount necessary to satisfy a residual value guarantee provided by the lessee, becomes probable. If collectibility is not probable at the commencement date, a lessor shall continue to assess collectibility to determine whether the lease payments and any amount necessary to satisfy a residual value guarantee are probable of collection. b. Either of the following events occurs: 1. The contract has been terminated, and the lease payments received from the lessee are nonrefundable. 2. The lessor has repossessed the underlying asset, it has no further obligation under the contract to the lessee, and the lease payments received from the lessee are nonrefundable When collectibility is not probable at the commencement date, at the date the criterion in paragraph (a) is met (that is, the date at which collectibility of the lease payments plus any amount necessary to satisfy a residual value guarantee provided by the lessee is assessed as probable), the lessor shall do all of the following: a. Derecognize the carrying amount of the underlying asset b. Derecognize the carrying amount of any deposit liability recognized in accordance with paragraph c. Recognize a net investment in the lease on the basis of the remaining lease payments and remaining lease term, using the rate implicit in the lease determined at the commencement date d. Recognize selling profit or selling loss calculated as: 1. The lease receivable; plus 2. The carrying amount of the deposit liability; minus 2. The carrying amount of the underlying asset, net of the unguaranteed residual asset When collectibility is not probable at the commencement date, at the date the criterion in paragraph (b) is met, the lessor shall derecognize the carrying amount of any deposit liability recognized in accordance with paragraph , with the corresponding amount recognized as lease income If collectibility is probable at the commencement date for a sales-type lease or for a direct financing lease, a lessor shall not reassess whether collectibility is probable. Subsequent changes in the credit risk of the lessee shall be accounted for in accordance with the impairment guidance applicable to the net investment in the lease in paragraph Technical Line A closer look at the new leases standard 31 March 2016

111 Derecognition At the commencement date, a lessor shall derecognize the carrying amount of the underlying asset (if previously recognized) unless the lease is a sales-type lease and collectibility of the lease payments is not probable (see paragraph ). Initial Measurement At the commencement date, for a sales-type lease, a lessor shall measure the net investment in the lease to include both of the following: a. The lease receivable, which is measured at the present value, discounted using the rate implicit in the lease, of: 1. The lease payments (as described in paragraph ) not yet received by the lessor 2. The amount the lessor expects to derive from the underlying asset following the end of the lease term that is guaranteed by the lessee or any other third party unrelated to the lessor b. The unguaranteed residual asset at the present value of the amount the lessor expects to derive from the underlying asset following the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, discounted using the rate implicit in the lease Collectibility is probable at lease commencement At lease commencement, a lessor accounts for a sales-type lease for which the collectibility of lease payments and any residual value guarantee provided by the lessee is probable as follows: Derecognizes the carrying amount of the underlying asset Recognizes the net investment in the lease (refer to section 5.1.1, Net investment in the lease) Recognizes, in net income, any selling profit or selling loss (refer to section 5.1.2, Selling profit or selling loss) Expenses any initial direct costs if the fair value of the underlying asset is different from its carrying amount (refer to section 2.6, Initial direct costs, and section 2.8, Fair value) Defers any initial direct costs and includes them in the net investment in the lease if the fair value of the underlying asset equals its carrying amount If initial direct costs are deferred, they are included in the computation of the rate implicit in the lease and therefore automatically included in the measurement of the net investment in the lease. Refer to section 2.5, Discount rates, for further discussion of the rate implicit in the lease. A lessor does not change lease classification after lease commencement due to changes in the assessment of collectibility. Subsequent changes in the collectibility of the lessee are identified and accounted for in the impairment assessment of the net investment in the sales-type lease. Refer to section 5.2.3, Impairment of the net investment in the lease. 111 Technical Line A closer look at the new leases standard 31 March 2016

112 Collectibility is not probable at lease commencement If the collection of the lease payments and any residual value guarantee provided by the lessee is not probable at lease commencement for a sales-type lease, a lessor does not derecognize the underlying asset and does not recognize its net investment in the lease. Instead, a lessor continues to account for the underlying asset using other US GAAP (e.g., depreciates the asset in accordance with ASC 360) and recognizes lease payments received, including variable lease payments that do not depend on an index or rate, as a deposit liability until the earlier of either of the following: Collection of the lease payments, plus any amount necessary to satisfy a residual value guarantee provided by the lessee, becomes probable. Either of the following events occurs: The contract is terminated, and the lease payments received from the lessee are nonrefundable. The lessor repossesses the underlying asset and has no further obligation to the lessee under the contract and the lease payments received from the lessee are nonrefundable. Collectibility of lease payments and any residual value guarantee provided by the lessee is continually reassessed when collection is not probable at the commencement date. Collectibility is not probable at lease commencement but subsequently becomes probable When collectibility of lease payments and any residual value guarantee provided by the lessee is not probable at lease commencement but subsequently becomes probable, a lessor accounts for the sales-type lease as follows: Derecognizes the carrying amount of the underlying asset Derecognizes the carrying amount of any deposit liability recognized Recognizes a net investment in the lease, measured based on the remaining lease payments and remaining lease term, using the rate implicit in the lease determined at the commencement date Recognizes selling profit or selling loss calculated as: The lease receivable Plus the carrying amount of the deposit liability Minus the carrying amount of the underlying asset, net of the unguaranteed residual asset Collectibility is not probable at lease commencement and the contract is subsequently terminated or the underlying asset is repossessed by the lessor When collectibility of lease payments and any residual value guarantee provided by the lessee is not probable at lease commencement, a lessor derecognizes the carrying amount of any deposit liability previously recognized and recognizes lease income when the lease payments received from the lessee are nonrefundable and either: The contract terminates. The lessor repossesses the underlying asset and has no further obligation to the lessee under the contract. 112 Technical Line A closer look at the new leases standard 31 March 2016

113 5.2.2 Subsequent measurement ASC 842 s subsequent measurement guidance for sales-type leases is similar to the subsequent measurement guidance for direct financing leases, discussed in section 5.3.2, Subsequent measurement. Deferring selling profit as part of the net investment in the lease (for direct financing leases) is the key difference. Leases Lessor Subsequent Measurement After the commencement date, a lessor shall measure the net investment in the lease by doing both of the following: a. Increasing the carrying amount to reflect the interest income on the net investment in the lease. A lessor shall determine the interest income on the net investment in the lease in each period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the net investment in the lease. b. Reducing the carrying amount to reflect the lease payments collected during the period. Recognition After the commencement date, a lessor shall recognize all of the following: a. Interest income on the net investment in the lease, measured in accordance with paragraph (a) b. Variable lease payments that are not included in the net investment in the lease as income in profit or loss in the period when the changes in facts and circumstances on which the variable lease payments are based occur c. Impairment of the net investment in the lease (as described in paragraph ). After lease commencement, a lessor accounts for a sales-type lease as follows: Recognizes interest income (in profit or loss) over the lease term in an amount that produces a constant periodic discount rate on the remaining balance of the net investment in the lease (i.e., using the rate implicit in the lease), including: Interest on the lease receivable Interest from accretion of the unguaranteed residual asset to its expected value at the end of the lease Reduces the net investment in the lease for lease payments received (net of interest income calculated above) Separately recognizes income from variable lease payments that are not included in the net investment in the lease (e.g., performance- or usage-based variable payments) in the period when the changes in facts and circumstances on which the variable lease payments are based occur Recognizes changes to variable lease payments that depend on an index or rate in profit or loss in the period of the change 113 Technical Line A closer look at the new leases standard 31 March 2016

114 Recognizes any impairment of the net investment in the lease (refer to section 5.2.3, Impairment of the net investment in the lease) Impairment of the net investment in the lease Leases Lessor Subsequent Measurement A lessor evaluates its net investment (inclusive of the unguaranteed residual value) in sales-type and direct financing leases for impairment using the guidance for receivables in ASC A lessor shall determine impairment related to the net investment in the lease and shall recognize any impairment in accordance with Topic 310 on receivables (as described in paragraphs through 35-30). When determining the loss allowance for a net investment in the lease, a lessor shall take into consideration the collateral relating to the net investment in the lease. The collateral relating to the net investment in the lease represents the cash flows that the lessor would expect to derive from the underlying asset during the remaining lease term (for example, from sale of the asset or release of the asset for the remainder of the lease term), which excludes the cash flows that the lessor would expect to derive from the underlying asset following the end of the lease term (for example, cash flows from leasing the asset after the end of the lease term). ASC 842 requires lessors to evaluate their net investment in a sales-type lease and a direct financing lease (refer to section 5.3, Direct financing leases) for impairment using the guidance for receivables in ASC 310. The FASB indicated in the Basis for Conclusions (BC 310) that even though the unguaranteed residual asset component of the net investment in the lease does not meet the definition of a financial asset in US GAAP, it would be overly complex and provide little benefit to require entities to separately assess the unguaranteed residual asset for impairment in accordance with ASC 360 while the receivable (i.e., the financial asset) is evaluated for impairment in accordance with ASC 310. When determining the loss allowance for a net investment in the lease, a lessor takes into consideration the collateral relating to the net investment in the lease, which represents the cash flows that the lessor would expect to derive from the underlying asset during the remaining lease term (e.g., cash flows from selling the asset or re-leasing it for the remainder of the lease term). This excludes the cash flows that the lessor would expect to derive from the underlying asset following the end of the lease term (e.g., cash flows from leasing the asset after the end of the lease term) Remeasurement of the net investment in the lease ASC 842 s remeasurement provisions for a net investment in a sales-type lease are the same as for a direct financing lease, discussed in section 5.3.4, Remeasurement of the net investment in the lease. Leases Lessor Subsequent Measurement After the commencement date, a lessor shall not remeasure the net investment in the lease unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph Technical Line A closer look at the new leases standard 31 March 2016

115 After lease commencement, the net investment in a sales-type lease is not remeasured unless the lease is modified (i.e., there is a change to the terms and conditions of a contract that results in a change in the scope of or the consideration for the lease) and the modified lease is not accounted for as a separate contract. Refer to section 5.6, Lease modifications. Additionally, ASC requires lessors to account for a lessee s exercise of an option to extend or terminate the lease or purchase the underlying asset as a lease modification. That is, lessors remeasure the net investment in a sales-type lease upon the exercise of these options. Lessees are not required to account for such exercises as a lease modification. How we see it We believe that the exercise of an option to extend or terminate the lease or purchase the underlying asset should be accounted for in the same manner as a lease modification only when the exercise of the option is inconsistent with the lessor s assumption about whether the lessee will exercise the option. For example, if a lessor included an optional period to extend the lease in the lease term because it concluded that the lessee is reasonably certain to exercise that option, we do not believe that the exercise of the option should be accounted for as a lease modification Example lessor accounting for a sales-type lease The following illustration shows how a lessor accounts for a sales-type lease that gives rise to selling profit when the collectibility of lease payments and the residual value guarantee provided by the lessee is probable at lease commencement. Refer to section 5.5, Examples lessor accounting, for additional examples of lessor accounting included in ASC 842. Illustration 13 Lessor accounting for a sales-type lease Assume Entity X (Lessor) enters into a 10-year lease of equipment with Entity Y (Lessee). Lessor sells and leases the equipment, which is not specialized in nature and is expected to have alternative use to Lessor at the end of the 10-year lease term. Under the lease: Lessor receives annual lease payments of $15,000, payable at the end of the year. Lessor expects the residual value of the equipment to be $50,000 at the end of the 10-year lease term. Lessee provides a residual value guarantee that protects Lessor on the first $30,000 of loss below the estimated residual value at the end of the lease term of $50,000. The equipment has an estimated remaining economic life of 15 years, a carrying amount of $100,000 and a fair value of $111,000. Lessor incurred costs of $2,000 for a broker s commission as a result of obtaining the lease. These costs qualify as initial direct costs and are capitalized when the lease is obtained. The lease does not transfer ownership of the underlying asset to Lessee at the end of the lease term or contain an option for Lessee to purchase the equipment. The rate implicit in the lease is %. At lease commencement, Lessor concludes that it is probable it will collect the lease payments and any amount probable of being owed under the residual value guarantee provided by Lessee. 115 Technical Line A closer look at the new leases standard 31 March 2016

116 Lessor classifies the lease as a sales-type lease because the present value of the sum of lease payments and the residual value guaranteed by Lessee exceeds substantially all of the fair value of the underlying asset. None of the other criteria for classification as a sales-type lease are met. If the residual value guarantee was from an unrelated party other than the lessee, the Lessor would have excluded it when determining whether the lease met the requirements to be classified as a sales-type lease (refer to section 3.2, Criteria for lease classification lessors). At lease commencement, Lessor accounts for the sales-type lease as follows: To record the net investment in the sales-type lease and derecognize the underlying asset: Net investment in the lease $ 111,000 (a) Cost of goods sold 92,344 (b) Broker s commission expense 2,000 (c) Revenue $ 103,344 (d) Property held for lease 100,000 (e) Capitalized initial direct costs 2,000 (c) (a) The net investment in the lease consists of (1) the present value of the 10 annual lease payments of $15,000 plus the present value of the guaranteed residual value of $30,000, both discounted at the rate implicit in the lease, which equals $103,344 (i.e., the lease receivable) and (2) the present value of unguaranteed residual asset of $20,000, which equals $7,656. Note that the net investment in the lease is subject to the same considerations as other assets when classifying its components as current or noncurrent assets in a classified balance sheet. (b) Cost of goods sold is the carrying amount of the equipment of $100,000 less the present value of the unguaranteed residual asset of $7,656. (c) Costs incurred to pay a broker s commission as a result of obtaining the lease qualify as capitalizable initial direct costs but are expensed at lease commencement. (d) Revenue equals the lease receivable. (e) $100,000 is the carrying amount of the underlying asset. At lease commencement, Lessor recognizes selling profit of $11,000, which is calculated as the lease receivable of $103,344 less the carrying amount of the asset of $100,000, net of any unguaranteed residual asset of $7,656, which equals $92,344. Year 1 journal entries for the sales-type lease: Cash $ 15,000 (f) Net investment in the lease $ 3,813 (g) Interest income 11,187 (h) (f) Receipt of annual lease payment at the end of the year. (g) Reduction of the net investment in the lease for lease payment received of $15,000, net of interest income of $11,187. (h) Interest income is the amount that produces a constant periodic discount rate on the remaining balance of the net investment in the lease (see computation below). 116 Technical Line A closer look at the new leases standard 31 March 2016

117 The following table summarizes the interest income from this lease and the related amortization of the net investment over the lease term. Year Annual rental payment Annual interest income (a) Net investment at end of year Initial net investment $ $ $ 111, ,000 11, , ,000 10, , ,000 10,380 98, ,000 9,914 93, ,000 9,401 87, ,000 8,837 81, ,000 8,216 74, ,000 7,532 67, ,000 6,780 59, ,000 5,950 50,000 (b) (a) Interest income equals % of the net investment in the lease at the beginning of each year. For example, Year 1 annual interest income is calculated as $111,000 initial net investment x %. (b) The estimated residual value of the equipment at the end of the lease term. Immaterial differences may arise in the re-computation of amounts in the example above due to rounding. 5.3 Direct financing leases Initial recognition and measurement Leases Lessor Recognition At the commencement date, a lessor shall recognize both of the following and derecognize the underlying asset in accordance with paragraph : a. A net investment in the lease, measured in accordance with paragraph b. Selling loss arising from the lease, if applicable Selling profit and initial direct costs (see paragraphs through 30-10) are deferred at the commencement date and included in the measurement of the net investment in the lease. The rate implicit in the lease is defined in such a way that initial direct costs deferred in accordance with this paragraph are included automatically in the net investment in the lease; there is no need to add them separately If collectibility is probable at the commencement date for a sales-type lease or for a direct financing lease, a lessor shall not reassess whether collectibility is probable. Subsequent changes in the credit risk of the lessee shall be accounted for in accordance with the impairment guidance applicable to the net investment in the lease in paragraph Technical Line A closer look at the new leases standard 31 March 2016

118 Initial Measurement At the commencement date, for a sales-type lease, a lessor shall measure the net investment in the lease to include both of the following: a. The lease receivable, at the present value, discounted using the rate implicit in the lease, of: 1. The lease payments (as described in paragraph ) not yet received by the lessor 2. The amount the lessor expects to derive from the underlying asset following the end of the lease term that is guaranteed by the lessee or any other third party unrelated to the lessor b. The unguaranteed residual asset at the present value of the amount the lessor expects to derive from the underlying asset following the end of the lease term that is not guaranteed by the lessee or any other third party unrelated to the lessor, discounted using the rate implicit in the lease At the commencement date, for a direct financing lease, a lessor shall measure the net investment in the lease to include the items in paragraph (a) through (b), reduced by the amount of any selling profit. Derecognition At the commencement date, a lessor shall derecognize the carrying amount of the underlying asset (if previously recognized) unless the lease is a sales-type lease and collectibility of the lease payments is not probable (see paragraph ). As a reminder, the lease classification test is designed so that a lease can be a direct financing lease only when the lessor obtains a residual value guarantee from an unrelated third party other than the lessee and that guarantee is sufficient to satisfy the substantially all criterion discussed in section 3.2., Criteria for lease classification lessors. Although a residual value guarantee from an unrelated third party other than the lessee can exist in a sales-type lease or an operating lease, a lease without a residual value guarantee from an unrelated third party other than the lessee must be classified as either a sales-type lease or an operating lease. At lease commencement, a lessor accounts for a direct financing lease as follows: Derecognizes the carrying amount of the underlying asset Recognizes the net investment in the lease (refer to section 5.1.1, Net investment in the lease) Recognizes, in net income, any selling loss (refer to section 5.1.2, Selling profit or selling loss) Defers any selling profit and initial direct costs (refer to section 2.6, Initial direct costs) and includes those amounts in the initial measurement of the net investment in the lease 118 Technical Line A closer look at the new leases standard 31 March 2016

119 The initial measurement of the net investment in a direct financing lease is similar to that of a sales-type lease (i.e., the present value of the lease payments not yet received and the unguaranteed residual asset). However, for a direct financing lease, any selling profit is deferred at lease commencement and included in the initial measurement of the net investment in the lease (i.e., selling profit reduces the net investment in the lease). For a direct financing lease, because initial direct costs are deferred, they are included in the computation of the rate implicit in the lease and therefore automatically included in the measurement of the net investment in the lease (i.e., initial direct costs increase the net investment in the lease). Refer to section 2.5, Discount rates, for further discussion of the rate implicit in the lease. The lease classification test is designed so that that in order for a lessor to classify a lease as a direct financing lease, the collection of lease payments and any residual value guarantee (i.e., those guarantees provided by the lessee and any other third party unrelated to the lessor) must be probable at the commencement date. A lessor does not change lease classification after lease commencement due to changes in the assessment of collectibility. Subsequent changes in collectibility are identified and accounted for in the impairment assessment of the net investment in the direct financing lease. Refer to section 5.3.3, Impairment of the net investment in the lease Subsequent measurement ASC 842 s subsequent measurement guidance for direct financing leases is similar to the subsequent measurement guidance for sales-type leases, discussed in section 5.2.2, Subsequent measurement. Deferring selling profit as part of the net investment in the lease (for direct financing leases) is the key difference. Leases Lessor Subsequent Measurement After the commencement date, a lessor shall measure the net investment in the lease by doing both of the following: a. Increasing the carrying amount to reflect the interest income on the net investment in the lease. A lessor shall determine the interest income on the net investment in the lease in each period during the lease term as the amount that produces a constant periodic discount rate on the remaining balance of the net investment in the lease. b. Reducing the carrying amount to reflect the lease payments collected during the period. Recognition After the commencement date, a lessor shall recognize all of the following: a. Interest income on the net investment in the lease, measured in accordance with paragraph (a) b. Variable lease payments that are not included in the net investment in the lease as income in profit or loss in the period when the changes in facts and circumstances on which the variable lease payments are based occur c. Impairment of the net investment in the lease (as described in paragraph ). 119 Technical Line A closer look at the new leases standard 31 March 2016

120 After lease commencement, a lessor accounts for a direct financing lease as follows: Recognizes interest income (in profit or loss) over the lease term in an amount that produces a constant periodic discount rate on the remaining balance of the net investment in the lease including: Interest on the lease receivable Interest from accretion of the unguaranteed residual asset to its expected value at the end of the lease Amortization of any deferred selling profit Reduces the net investment in the lease for lease payments received (net of interest income calculated above) Separately recognizes income from variable lease payments that are not included in the net investment in the lease (e.g., performance- or usage-based variable payments) in the period when the changes in facts and circumstances on which the variable lease payments are based occur Recognizes changes to variable lease payments that depend on an index or rate in profit or loss in the period of the change Recognizes any impairment of the net investment in the lease (refer to section 5.2.3, Impairment of the net investment in the lease) Note that as illustrated in section 5.3.5, Example lessor accounting for a direct financing lease, the rate used to recognize interest income on a direct financing lease differs from the rate implicit in the lease when there is deferred selling profit Impairment of the net investment in the lease Leases Lessor Subsequent Measurement A lessor shall determine impairment related to the net investment in the lease and shall recognize any impairment in accordance with Topic 310 on receivables (as described in paragraphs through 35-30). When determining the loss allowance for a net investment in the lease, a lessor shall take into consideration the collateral relating to the net investment in the lease. The collateral relating to the net investment in the lease represents the cash flows that the lessor would expect to derive from the underlying asset during the remaining lease term (for example, from sale of the asset or release of the asset for the remainder of the lease term), which excludes the cash flows that the lessor would expect to derive from the underlying asset following the end of the lease term (for example, cash flows from leasing the asset after the end of the lease term). ASC 842 s provisions for evaluating impairment of the net investment in a direct financing lease are the same as for a sales-type lease. Refer to section 5.2.3, Impairment of the net investment in the lease, for further discussion Remeasurement of the net investment in the lease ASC 842 s remeasurement provisions for the net investment in a direct financing lease are the same as for a sales-type lease, discussed in section 5.2.4, Remeasurement of the net investment in the lease. 120 Technical Line A closer look at the new leases standard 31 March 2016

121 Leases Lessor Subsequent Measurement After the commencement date, a lessor shall not remeasure the net investment in the lease unless the lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph After lease commencement, the net investment in a direct financing lease is not remeasured unless the lease is modified (i.e., there is a change to terms and conditions of a contract that results in a change in the scope of or the consideration for the lease) and the modified lease is not accounted for as a separate contract. Refer to section 5.6, Lease modifications. Additionally, ASC requires lessors to account for a lessee s exercise of an option to extend or terminate the lease or purchase the underlying asset as a lease modification. That is, lessors remeasure the net investment in a direct financing lease upon the exercise of these options. Lessees are not required to account for such exercises as a lease modification. How we see it We believe that the exercise of an option to extend or terminate the lease or purchase the underlying asset should be accounted for in the same manner as a lease modification only when the exercise of the option is inconsistent with the lessor s assumption about whether the lessee will exercise the option. For example, if a lessor included an optional period to extend the lease in the lease term because it concluded that the lessee is reasonably certain to exercise that option, we do not believe that the exercise of the option should be accounted for as a lease modification Example lessor accounting for a direct financing lease The following illustration shows how a lessor accounts for a direct financing lease that gives rise to selling profit. Refer to section 5.5, Examples lessor accounting, for additional examples of lessor accounting included in ASC 842. Illustration 14 Lessor accounting for a direct financing lease Assume Entity X (Lessor) enters into a 10-year lease of equipment with Entity Y (Lessee). Lessor sells and leases the equipment, which is not specialized in nature and is expected to have alternative use to Lessor at the end of the 10-year lease term. Under the lease: Lessor receives annual lease payments of $15,000, payable at the end of each year. Lessor expects the residual value of the equipment to be $50,000 at the end of the 10-year lease term. Lessor obtains a residual value guarantee from an unrelated third party other than Lessee that protects Lessor on the first $30,000 of loss below the estimated residual value of $50,000. The equipment has an estimated remaining economic life of 15 years, a carrying amount of $100,000 and a fair value of $111,000. The lease does not transfer ownership of the underlying asset to Lessee at the end of the lease term or contain an option for Lessee to purchase the underlying asset. The rate implicit in the lease is %. At lease commencement, Lessor concludes that it is probable it will collect the lease payments and any amount owed under the residual value guarantee provided by the third party. 121 Technical Line A closer look at the new leases standard 31 March 2016

122 None of the criteria for a classification as a sales-type lease are met (e.g., the present value of the lease payments is 83% of the fair value of the equipment, which is less than the 90% threshold that Lessor uses in the lease classification test). Lessor classifies the lease as a direct financing lease because (1) the present value of the sum of the lease payments and the residual value guaranteed by the unrelated third party exceeds substantially all of the fair value of the underlying asset and (2) it is probable that Lessor will collect the lease payments and any amount owed under the residual value guarantee. If the residual value guarantee was provided by Lessee, the lease would be classified as a sales-type lease (refer to section 3.2, Criteria for lease classification lessors). At lease commencement, Lessor accounts for the direct financing lease as follows: To record the net investment in the direct financing lease and derecognize the underlying asset: Net investment in the lease $ 100,000 (a) Property held for lease 100,000 (b) (a) The net investment in the lease consists of (1) the present value of the 10 annual lease payments of $15,000 plus the present value of the guaranteed residual value of $30,000, both discounted at the rate implicit in the lease, which equals $103,344 (i.e., the lease receivable), plus (2) the present value of unguaranteed residual asset of $20,000, which equals $7,656, less (3) deferred selling profit of $11,000. Deferred selling profit is calculated as the lease receivable of $103,344, less the carrying amount of the underlying asset of $100,000, net of any unguaranteed residual asset of $7,656. Note that the net investment in the lease is subject to the same considerations as other assets when classifying its components as current or noncurrent assets in a classified balance sheet. (b) $100,000 is the carrying amount of the underlying asset. Year 1 journal entries for the direct financing lease: Cash $ 15,000 (c) Net investment in the lease $ 2,825 (d) Interest income 12,175 (e) (c) Receipt of annual lease payment at the end of the year. (d) Reduction of the net investment in the lease for lease payment received of $15,000, net of interest income of $12,175. (e) Interest income is the amount that produces a constant periodic discount rate on the remaining balance of the net investment in the lease (see computation below). The following table summarizes the interest income for this lease and the related amortization of the net investment over the lease term. Year Annual rental payment Annual interest income (a) Net investment at end of year Initial net investment $ $ $ 100, ,000 12,175 97, ,000 11,831 94, ,000 11,445 90, ,000 11,012 86, ,000 10,527 81, ,000 9,982 76, ,000 9,371 71, ,000 8,686 65, ,000 7,917 57, ,000 7,054 50,000 (b) (a) Interest income includes interest on the lease receivable, accretion of the unguaranteed residual asset and amortization of deferred selling profit. The rate for recognizing interest income to produce a constant periodic rate of return on the remaining net investment is %. (b) The estimated residual value of the equipment at the end of the lease term. 122 Technical Line A closer look at the new leases standard 31 March 2016

123 The following table summarizes the components of interest income recognized over the lease term. Year Interest on lease receivable (a) Accretion of unguaranteed residual asset (b) Amortization of deferred selling profit (c) Annual interest income 1 $ 10,415 $ 772 $ 988 $ 12, , ,028 11, , ,065 11, ,885 1,029 1,098 11, ,269 1,133 1,125 10, ,590 1,247 1,145 9, ,843 1,373 1,155 9, ,021 1,511 1,154 8, ,117 1,663 1,137 7, ,119 1,831 1,104 7,054 (a) Interest on the lease receivable is based on the rate implicit in the lease of %. For example, Year 1 interest on the lease receivable is calculated as the lease receivable of $103,344 multiplied by the rate implicit in the lease of %. (b) Accretion of the unguaranteed residual asset is based on the rate implicit in the lease of %. For example, Year 1 accretion of the residual asset is calculated as the present value of the unguaranteed residual asset at lease commencement of $7,656 multiplied by the rate implicit in the lease of %. (c) Deferred selling profit is amortized into interest income over the lease term in a manner that, when combined with the interest income on the lease receivable and unguaranteed residual asset, produces a constant periodic rate of return on the lease of %. Immaterial differences may arise in the re-computation of amounts in the example above due to rounding. 5.4 Operating leases Leases Lessor Recognition At the commencement date, a lessor shall defer initial direct costs After the commencement date, a lessor shall recognize all of the following: a. The lease payments as income in profit or loss over the lease term on a straight-line basis unless another systematic and rational basis is more representative of the pattern in which benefit is expected to be derived from the use of the underlying asset, subject to paragraph b. Variable lease payments as income in profit or loss in the period in which the changes in facts and circumstances on which the variable lease payments are based occur c. Initial direct costs as an expense over the lease term on the same basis as lease income (as described in (a)) If collectibility of the lease payments plus any amount necessary to satisfy a residual value guarantee (provided by the lessee or any other unrelated third party) is not probable at the commencement date, lease income shall be limited to the lesser of the income that would be recognized in accordance with paragraph (a) through (b) or the lease payments, including variable lease payments, that have been collected from the lessee. 123 Technical Line A closer look at the new leases standard 31 March 2016

124 If the assessment of collectibility changes after the commencement date, any difference between the lease income that would have been recognized in accordance with paragraph (a) through (b) and the lease payments, including variable lease payments, that have been collected from the lessee shall be recognized as a current-period adjustment to lease income. Initial Measurement A lessor shall continue to measure the underlying asset subject to an operating lease in accordance with other Topics. Subsequent Measurement A lessor shall continue to measure, including testing for impairment in accordance with Section on impairment or disposal of long-lived assets, the underlying asset subject to an operating lease in accordance with other Topics. Under ASC 842, lessors account for operating leases in a manner similar to how they account for operating leases under ASC 840. Under ASC 842, lessors account for operating leases in a manner similar to how they account for operating leases under ASC 840. That is, they continue to recognize the underlying asset and do not recognize a net investment in the lease on the balance sheet or initial profit (if any) in the income statement. The underlying asset continues to be accounted for in accordance with ASC 360. If the collection of lease payments and any residual value guarantee (i.e., guarantees provided by the lessee or any other third party unrelated to the lessor) for an operating lease is probable at lease commencement, a lessor subsequently recognizes lease income over the lease term on a straight-line basis unless another systematic and rational basis better represents the pattern in which benefit is expected to be derived from the use of the underlying asset. After lease commencement, lessors recognize variable lease payments that do not depend on an index or rate (e.g., performance- or usage-based payments) when the changes in facts and circumstances on which the variable lease payments are based occur. Similarly, lessors recognize changes to variable lease payments that depend on an index or rate in profit or loss in the period of the change. If the collection of the lease payments and any residual value guarantee is not probable at the commencement date for an operating lease (including a lease that would otherwise have qualified as a direct financing lease if it had met the collectibility requirements refer to section 3.2, Criteria for lease classification lessors), a lessor s lease income is limited to the lesser of (1) the income that would have been recognized if collection were probable, including income from variable lease payments, and (2) the lease payments, including variable lease payments, that have been collected from the lessee. If the collectibility assessment changes to probable after the commencement date, any difference between the lease income that would have been recognized if collectibility had always been assessed as probable and the income recognized to date is recognized as a current-period adjustment to lease income. Likewise, if the collectibility assessment changes to not probable after the commencement date, income is reversed if the lease payments, including variable lease payments, that have been collected from the lessee are less than the income recognized to date. A lessor does not reassess lease classification if the collection of lease payments becomes probable after lease commencement. For example, a lease that would have otherwise been classified as a direct financing lease except that collectibility of lease payments and any 124 Technical Line A closer look at the new leases standard 31 March 2016

125 residual value guarantee was not probable at lease commencement is classified as an operating lease. If the lease payments and any residual value guarantee are subsequently determined to be probable of collection, the lease continues to be classified as an operating lease. However, a change in collectibility could affect the timing of recognition of income. The FASB said in the Basis for Conclusions (BC ) that recognizing rental income on a straight-line basis often will reflect the pattern in which income is earned from the underlying asset. However, the FASB said that will not always be the case and decided that a lessor can recognize rental income on another systematic and rational basis if it is more representative of the pattern in which benefit is expected to be derived from the use of the underlying asset. The FASB further said that a lessor is expected to recognize uneven fixed lease payments on a straight-line basis when the payments are uneven for reasons other than to reflect or compensate for market rentals or market conditions (for example, when there is significant front loading or back loading of payments or when rent-free periods exist in a lease). How we see it Determining that lease payments in an operating lease should be recognized on a basis other than straight line will likely require judgment. There might not be a clear distinction between increases in scheduled lease payments that reflect the pattern in which lease income is earned (e.g., stepped increases to compensate the lessor for changes in the market rentals) and other scheduled increases that do not. Initial direct costs ASC 842 requires lessors of operating leases to defer initial direct costs at lease commencement and amortize them over the lease term on the same basis as lease income. 5.5 Examples lessor accounting ASC 842 includes the following example of the accounting for a sales-type lease for which the collection of lease payments and the residual value guarantee provided by the lessee is probable at lease commencement. Leases Lessors Implementation Guidance and Illustration Example 1 Lessor Accounting Example Case A Lessor Accounting Sales-Type Lease Lessor enters into a 6-year lease of equipment with Lessee, receiving annual lease payments of $9,500, payable at the end of each year. Lessee provides a residual value guarantee of $13,000. Lessor concludes that it is probable it will collect the lease payments and any amount necessary to satisfy the residual value guarantee provided by Lessee. The equipment has a 9-year estimated remaining economic life, a carrying amount of $54,000, and a fair value of $62,000 at the commencement date. Lessor expects the residual value of the equipment to be $20,000 at the end of the 6-year lease term. The lease does not transfer ownership of the underlying asset to Lessee or contain an option for Lessee to purchase the underlying asset. Lessor incurs $2,000 in initial direct costs in connection with obtaining the lease, and no amounts are prepaid by Lessee to Lessor. The rate implicit in the lease is percent. 125 Technical Line A closer look at the new leases standard 31 March 2016

126 Lessor classifies the lease as a sales-type lease because the sum of the present value of the lease payments and the present value of the residual value guaranteed by the lessee amounts to substantially all of the fair value of the equipment. None of the other criteria to be classified as a sales-type lease are met Lessor measures the net investment in the lease at $62,000 at lease commencement, which is equal to the fair value of the equipment. The net investment in the lease consists of the lease receivable (which includes the 6 annual payments of $9,500 and the residual value guarantee of $13,000, both discounted at the rate implicit in the lease, which equals $56,920) and the present value of the unguaranteed residual value (the present value of the difference between the expected residual value of $20,000 and the residual value guarantee of $13,000, which equals $5,080). Lessor calculates the selling profit on the lease as $8,000, which is the difference between the lease receivable ($56,920) and the carrying amount of the equipment net of the unguaranteed residual asset ($54,000 $5,080 = $48,920). The initial direct costs do not factor into the calculation of the selling profit in this Example because they are not eligible for deferral on the basis of the guidance in paragraph (c) (that is, because the fair value of the underlying asset is different from its carrying amount at the commencement date) At the commencement date, Lessor derecognizes the equipment (carrying amount of $54,000) and recognizes the net investment in the lease of $62,000 and the selling profit of $8,000. Lessor also pays and recognizes the initial direct costs of $2,000 as an expense At the end of Year 1, Lessor recognizes the receipt of a lease payment of $9,500 and interest on the net investment in the lease (the beginning balance of the net investment in the lease of $62,000 the rate implicit in the lease of % = $3,400), resulting in a balance in the net investment of the lease of $55,900. For disclosure purposes, Lessor also calculates the separate components of the net investment in the lease: the lease receivable and the unguaranteed residual asset. The lease receivable equals $50,541 (the beginning balance of the lease receivable of $56,920 the annual lease payment received of $9,500 + the amount of interest income on the lease receivable during Year 1 of $3,121, which is $56, %). The unguaranteed residual asset equals $5,360 (the beginning balance of the unguaranteed residual asset of $5,081 + the 140 interest income on the unguaranteed residual asset during Year 1 of $279, which is $5, %) At the end of Year 6, Lessor reclassifies the net investment in the lease, then equal to the estimated residual value of the underlying asset of $20,000, as equipment. The following example assumes the same facts as in Case A above except that the collection of lease payments and the residual value guarantee provided by the lessee is not probable at lease commencement. 126 Technical Line A closer look at the new leases standard 31 March 2016

127 Implementation Guidance and Illustration Example 1 Lessor Accounting Example Case B Lessor Accounting Sales-Type Lease Collectibility of the Lease Payments Is Not Probable Assume the same facts and circumstances as in Case A (paragraphs through 55-24), except that it is not probable Lessor will collect the lease payments and any amount necessary to satisfy the residual value guarantee provided by Lessee. In reaching this conclusion, the entity observes that Lessee s ability and intention to pay may be in doubt because of the following factors: a. Lessee intends to make the lease payments primarily from income derived from its business in which the equipment will be used (which is a business facing significant risks because of high competition in the industry and Lessee s limited experience) b. Lessee has limited credit history and no significant other income or assets with which to make the payments if the business is not successful In accordance with paragraph , Lessor does not derecognize the equipment and does not recognize a net investment in the lease or any selling profit or selling loss. However, consistent with Case A, Lessor pays and recognizes the initial direct costs of $2,000 as an expense at the commencement date At the end of Year 1, Lessor reassesses whether it is probable it will collect the lease payments and any amount necessary to satisfy the residual value guarantee provided by Lessee and concludes that it is not probable. In addition, neither of the events in paragraph (b) has occurred. The contract has not been terminated and Lessor has not repossessed the equipment because Lessee is fulfilling the terms of the contract. Consequently, Lessor accounts for the $9,500 Year 1 lease payment as a deposit liability in accordance with paragraph Lessor recognizes depreciation expense on the equipment of $7,714 ($54,000 carrying value 7-year useful life) Lessor s accounting in Years 2 and 3 is the same as in Year 1. At the end of Year 4, Lessee makes the fourth $9,500 annual lease payment such that the deposit liability equals $38,000. Lessor concludes that collectibility of the lease payments and any amount necessary to satisfy the residual value guarantee provided by Lessee is now probable on the basis of Lessee s payment history under the contract and the fact that Lessee has been successfully operating its business for four years. Lessor does not reassess the classification of the lease as a sales-type lease Consequently, at the end of Year 4, Lessor derecognizes the equipment, which has a carrying amount of $23,143, and recognizes a net investment in the lease of $35,519. The net investment in the lease consists of the lease receivable (the sum of the 2 remaining annual payments of $9,500 and the residual value guarantee of $13,000, discounted at the rate implicit in the lease of percent determined at the commencement date, which equals $29,228) and the unguaranteed residual asset (the present value of the 127 Technical Line A closer look at the new leases standard 31 March 2016

128 difference between the expected residual value of $20,000 and the residual value guarantee of $13,000, which equals $6,291). Lessor recognizes selling profit of $50,376, the difference between (a) the sum of the lease receivable and the carrying amount of the deposit liability ($29,228 lease receivable + $38,000 in lease payments already made = $67,228) and (b) the carrying amount of the equipment, net of the unguaranteed residual asset ($23,143 $6,291 = $16,852) After the end of Year 4, Lessor accounts for the remaining two years of the lease in the same manner as any other sales-type lease. Consistent with Case A, at the end of Year 6, Lessor reclassifies the net investment in the lease, then equal to the estimated residual value of the underlying asset of $20,000, as equipment. The following example assumes the same facts as in Case A above except that the lease is classified as a direct financing lease because the residual value guarantee is provided by a third party unrelated to the lessee. Implementation Guidance and Illustration Example 1 Lessor Accounting Example Case C Lessor Accounting Direct Financing Lease Assume the same facts and circumstances as in Case A (paragraphs through 55-24), except that the $13,000 residual value guarantee is provided by a third party, not by Lessee. Collectibility of the lease payments and any amount necessary to satisfy the third party residual value guarantee is probable None of the criteria in paragraph to be classified as a sales-type lease are met. Lessor classifies the lease as a direct financing lease because the sum of the present value of the lease payments and the present value of the residual value guaranteed by the third party amounts to substantially all of the fair value of the equipment. In accordance with paragraph , the discount rate used to determine the present value of the lease payments and the guaranteed residual value ( percent) assumes that no initial direct costs will be deferred because, at the commencement date, the fair value of the equipment is different from its carrying amount At the commencement date, Lessor derecognizes the equipment and recognizes a net investment in the lease of $56,000, which is equal to the carrying amount of the underlying asset of $54,000 plus the initial direct costs of $2,000 that are included in the measurement of the net investment in the lease in accordance with paragraph (that is, because the lease is classified as a direct financing lease). The net investment in the lease includes a lease receivable of $58,669 (the present value of the 6 annual lease payments of $9,500 and the third-party residual value guarantee of $13,000, discounted at the rate implicit in the lease of percent), an unguaranteed residual asset of $5,331 (the present value of the difference between the estimated residual value of $20,000 and the third-party residual value guarantee of $13,000, discounted at percent), and deferred selling profit of $8, Technical Line A closer look at the new leases standard 31 March 2016

129 Lessor calculates the deferred selling profit of $8,000 in this Example as follows: a. The lease receivable ($58,669); minus b. The carrying amount of the equipment ($54,000), net of the unguaranteed residual asset ($5,331), which equals $48,669; minus c. The initial direct costs included in the measurement of the net investment in the lease ($2,000) At the end of Year 1, Lessor recognizes the receipt of the lease payment of $9,500 and interest on the net investment in the lease of $4,624 (the beginning balance of the net investment in the lease of $56,000 the discount rate that, at the commencement date, would have resulted in the sum of the lease receivable and the unguaranteed residual asset equaling $56,000, which is percent), resulting in a balance in the net investment of the lease of $51, Also at the end of Year 1, Lessor calculates, for disclosure purposes, the separate components of the net investment in the lease: the lease receivable, the unguaranteed residual asset, and the deferred selling profit. The lease receivable equals $51,895 (the beginning balance of the lease receivable of $58,669 the annual lease payment received of $9,500 + the amount of interest income on the lease receivable during Year 1 of $2,726, which is $58, %). The unguaranteed residual asset equals $5,578 (the beginning balance of the unguaranteed residual asset of $5,331 + the interest income on the unguaranteed residual asset during Year 1 of $247, which is $5, %). The deferred selling profit equals $6,349 (the initial deferred selling profit of $8,000 $1,651 recognized during Year 1 [the $1,651 is the difference between the interest income recognized on the net investment in the lease during Year 1 of $4,624 calculated in paragraph and the sum of the interest income earned on the lease receivable and the unguaranteed residual asset during Year 1]) At the end of Year 2, Lessor recognizes the receipt of the lease payment of $9,500 and interest on the net investment in the lease (the beginning of Year 2 balance of the net investment in the lease of $51, %, which is $4,222), resulting in a carrying amount of the net investment in the lease of $45, Also at the end of Year 2, Lessor calculates the separate components of the net investment in the lease. The lease receivable equals $44,806 (the beginning of Year 2 balance of $51,895 the annual lease payment received of $9,500 + the interest income earned on the lease receivable during Year 2 of $2,411, which is $51, %). The unguaranteed residual asset equals $5,837 (the beginning of Year 2 balance of the unguaranteed residual asset of $5,578 + the interest income earned on the unguaranteed residual asset during Year 2 of $259, which is $5, %). The deferred selling profit equals $4,797 (the beginning of Year 2 balance of deferred selling profit of $6,349 $1,552 recognized during Year 2 [the $1,552 is the difference between the interest income recognized on the net investment in the lease during Year 2 of $4,222 and the sum of the interest income earned on the lease receivable and the unguaranteed residual asset during Year 2]) At the end of Year 6, Lessor reclassifies the net investment in the lease, then equal to the estimated residual value of the underlying asset of $20,000, as equipment. 129 Technical Line A closer look at the new leases standard 31 March 2016

130 The following example assumes the same facts as in Case C above except that the collectibility of lease payments and the residual value guarantee provided by the third party unrelated to the lessee is not probable at lease commencement and the lease is classified as an operating lease. Implementation Guidance and Illustration Example 1 Lessor Accounting Example Case D Lessor Accounting Collectibility Is Not Probable Assume the same facts and circumstances as Case C (paragraphs through 55-39), except that collectibility of the lease payments and any amount necessary to satisfy the residual value guarantee provided by the third party is not probable and the lease payments escalate every year over the lease term. Specifically, the lease payment due at the end of Year 1 is $7,000, and subsequent payments increase by $1,000 every year for the remainder of the lease term. Because it is not probable that Lessor will collect the lease payments and any amount necessary to satisfy the residual value guarantee provided by the third party in accordance with paragraph , Lessor classifies the lease as an operating lease Lessor continues to measure the equipment in accordance with Topic 360 on property, plant, and equipment Because collectibility of the lease payments is not probable, Lessor recognizes lease income only when Lessee makes the lease payments, and in the amount of those lease payments. Therefore, Lessor only recognizes lease income of $7,000 at the point in time Lessee makes the end of Year 1 payment for that amount At the end of Year 2, Lessor concludes that collectibility of the remaining lease payments and any amount necessary to satisfy the residual value guarantee provided by the third party is probable; therefore, Lessor recognizes lease income of $12,000. The amount of $12,000 is the difference between lease income that would have been recognized through the end of Year 2 ($57,000 in total lease payments 6 years = $9,500 per year 2 years = $19,000) and the $7,000 in lease income previously recognized. Collectibility of the remaining lease payments remains probable throughout the remainder of the lease term; therefore, Lessor continues to recognize lease income of $9,500 each year. As illustrated in the example above, a lessor does not reassess lease classification solely due to collectibility of lease payments becoming probable after lease commencement (i.e., the lease remains an operating lease). 5.6 Lease modifications Master Glossary Lease Modification A change to the terms and conditions of a contract that results in a change in the scope of or the consideration for a lease (for example, a change to the terms and conditions of the contract that adds or terminates the right to use one or more underlying assets or extends or shortens the contractual lease term). 130 Technical Line A closer look at the new leases standard 31 March 2016

131 If a lease is modified (i.e., there is a change to the terms and conditions of a contract that results in a change in the scope of or the consideration for the lease), the modified contract is evaluated to determine whether it is or contains a lease (refer to section 1.3, Reassessment of the contract). If a lease continues to exist, lease modification can result in: A separate contract (refer to section 5.6.1, Determining whether a lease modification is accounted for as a separate contract) A change in the accounting for the existing lease (i.e., not a separate contract refer to section 5.6.2, Lessor accounting for a lease modification that is not accounted for as a separate contract) Refer to Appendix D, Summary of the accounting for lease modifications lessors Determining whether a lease modification is accounted for as a separate contract Leases Overall Recognition An entity shall account for a modification to a contract as a separate contract (that is, separate from the original contract) when both of the following conditions are present: a. The modification grants the lessee an additional right of use not included in the original lease (for example, the right to use an additional asset). a. The lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract. For example, the standalone price for the lease of one floor of an office building in which the lessee already leases other floors in that building may be different from the standalone price of a similar floor in a different office building, because it was not necessary for a lessor to incur costs that it would have incurred for a new lessee. A lessor accounts for a lease modification (i.e., a change to the terms and conditions of a contract that results in a change in the scope of or consideration for the lease) as a separate contract (i.e., separate from the original contract) when both of the following conditions are met: The modification grants the lessee an additional right of use that is not included in the original lease (e.g., a right to use an additional underlying asset). The lease payments increase commensurate with the standalone price for the additional right of use, adjusted for the circumstances of the particular contract. If both of these conditions are met, the lease modification results in two separate contracts, the unmodified original contract and a separate contract. Lessors account for the separate contract that contains a lease in the same manner as other new leases. If both of the conditions are not met, the modified lease is not accounted for as a separate contract. Refer to section 5.6.2, Lessor accounting for a modification that is not accounted for as a separate contract. The FASB indicated in the Basis for Conclusions (BC 176(a)) that the right to use an additional underlying asset (e.g., an additional floor of a building) will generally be a separate lease component, even if the modification granting that additional right of use does not create a separate contract. To illustrate, if an existing lease for a floor of a building is modified to 131 Technical Line A closer look at the new leases standard 31 March 2016

132 include a second floor, the right to use the second floor will often be a separate lease component from the right to use the first floor, even if the second floor is not accounted for under a separate contract. Refer to section 1.4.1, Identifying and separating lease components of a contract. If the lease modification grants the lessee the right to use the existing leased asset for an additional period of time (i.e., a period of time not included in the original lease agreement), the modified lease is not accounted for as a separate contract. In such cases, as indicated in the Basis for Conclusions (BC 176(b)), the modification only changes an attribute of the lessee s existing right to use the underlying asset that it already controls. This is the case even if the extended term is priced at market Lessor accounting for a modification that is not accounted for as a separate contract Master Glossary Effective Date of the Modification Lessors reassess lease classification at the effective date of a lease modification that is not accounted for as a separate contract. The date that a lease modification is approved by both the lessee and the lessor. Leases Overall Recognition If a lease is modified and that modification is not accounted for as a separate contract in accordance with paragraph , the entity shall reassess the classification of the lease as of the effective date of the modification based on its modified terms and conditions and the facts and circumstances as of that date (for example, the fair value and remaining economic life of the underlying asset as of that date) An entity shall account for initial direct costs, lease incentives, and any other payments made to or by the entity in connection with a modification to a lease in the same manner as those items would be accounted for in connection with a new lease. ASC 842 requires lessors to reassess lease classification at the effective date of a lease modification (i.e., the date that the lease modification is approved by both the lessee and the lessor) that is not accounted for as a separate contract. Lease classification is reassessed using the modified terms and conditions and the facts and circumstances as of that date including: The remaining economic life of the underlying asset on that date The fair value of the underlying asset on that date The discount rate for the lease on that date The remeasurement and reallocation of the remaining consideration in the contract on that date Lessors account for initial direct costs, lease incentives and any other payments made to or by the lessor in connection with the lease modification in the same manner as those items are accounted for in connection with a new lease. Refer to chapter 2, Key concepts. 132 Technical Line A closer look at the new leases standard 31 March 2016

133 Modification to an operating lease that is not accounted for as a separate contract Leases Overall Recognition If an operating lease is modified and the modification is not accounted for as a separate contract in accordance with paragraph , the lessor shall account for the modification as if it were a termination of the existing lease and the creation of a new lease that commences on the effective date of the modification as follows: a. If the modified lease is classified as an operating lease, the lessor shall consider any prepaid or accrued lease rentals relating to the original lease as a part of the lease payments for the modified lease. b. If the modified lease is classified as a direct financing lease or a sales-type lease, the lessor shall derecognize any deferred rent liability or accrued rent asset and adjust the selling profit or selling loss accordingly. Operating lease to operating lease If the original lease and the modified lease are both classified as operating leases (i.e., no change to lease classification), the lessor recognizes lease payments to be made under the modified lease, adjusted for any prepaid or accrued rent from the original lease, generally on a straight-line basis over the remaining lease term. Any initial direct costs incurred in connection with the modification are recognized as an expense over the lease term. We believe that any unamortized initial direct costs recognized prior to the modification also should continue to be recognized as an expense over the lease term. Operating lease to sales-type lease If the original lease was an operating lease and the modified lease is classified as a sales-type lease (i.e., lease classification changes), a lessor derecognizes the underlying asset and applies the initial recognition and measurement guidance for sales-type leases (refer to section 5.2.1, Initial recognition and measurement) and adjusts the selling profit or loss by any prepaid or accrued rent from the original lease that is derecognized. For modifications resulting in a sales-type lease with selling profit or loss, the profit or loss is recognized and any initial direct costs incurred in connection with the modification are expensed. Operating lease to direct financing lease If the original lease was an operating lease and the modified lease is classified as a direct financing lease (i.e., lease classification changes), the lessor derecognizes the underlying asset and applies the initial recognition and measurement guidance for direct financing leases (refer to section 5.3.1, Initial recognition and measurement) and adjusts the selling profit or loss by any prepaid or accrued rent from the original lease that is derecognized. A lessor recognizes any selling loss in profit or loss. Any selling profit and initial direct costs incurred in connection with the modification or the remaining unamortized initial direct costs related to the original lease are deferred and included in the measurement of the initial net investment in the modified lease. 133 Technical Line A closer look at the new leases standard 31 March 2016

134 ASC 842 includes the following example of a lessor s accounting for a modification of an operating lease that does not change lease classification. Implementation Guidance and Illustrations Example 20 Modification of an Operating Lease That Does Not Change Lease Classification Lessor enters into a 10-year lease with Lessee for 10,000 square feet of office space. The annual lease payments are $100,000 in the first year, increasing by 5 percent each year thereafter, payable in arrears. The lease term is not for a major part of the remaining economic life of the office space (40 years), and the present value of the lease payments is not substantially all of the fair value of the office space. Furthermore, the title does not transfer to Lessee as a consequence of the lease, the lease does not contain an option for Lessee to purchase the office space, and the asset is not specialized such that it clearly has an alternative use to Lessor at the end of the lease term. Consequently, the lease is classified as an operating lease At the beginning of Year 6, Lessee and Lessor agree to amend the original lease for the remaining 5 years to include an additional 10,000 square feet of office space in the same building for a total annual fixed payment of $150,000. The increase in total consideration is at a discount both to the current market rate for the new 10,000 square feet of office space and in the context of that particular contract. The modified lease continues to be classified as an operating lease At the effective date of the modification (at the beginning of Year 6), Lessor has an accrued lease rental asset of $76,331 (rental income recognized on a straight-line basis for the first 5 years of the lease of $628,895 [$1,257, years = $125,779 per year] less lease payments for the first 5 years of $552,564 [that is, $100,000 in Year 1, 105,000 in Year 2, $110,250 in Year 3, $115,763 in Year 4, and $121,551 in Year 5]) Because the change in pricing of the lease is not commensurate with the standalone price for the additional right-of-use asset, Lessor does not account for the modification as a new lease, separate from the original 10-year lease. Instead, Lessor accounts for the modified lease prospectively from the effective date of the modification, recognizing the lease payments to be made under the modified lease of $750,000 ($150,000 5 years), net of Lessor s accrued rent asset of $76,331, on a straight-line basis over the remaining 5-year lease term ($673,669 5 years = $134,734 per year). At the end of the lease, Lessor will have recognized as lease income the $1,302,564 in lease payments it receives from Lessee during the 10-year lease term. 134 Technical Line A closer look at the new leases standard 31 March 2016

135 ASC 842 includes the following example of a lessor s accounting for a modification to an operating lease that is not accounted for as a separate contract but changes lease classification (i.e., operating lease to sales-type lease). Implementation Guidance and Illustrations Example 21 Modification of an Operating Lease That Changes Lease Classification Case A Operating Lease to Sales-Type Lease Lessor enters into a four-year lease of a piece of nonspecialized equipment. The annual lease payments are $81,000 in the first year, increasing by 5 percent each year thereafter, payable in arrears. The estimated residual value of the equipment is $90,000, of which none is guaranteed. The remaining economic life of the equipment at lease commencement is seven years. The carrying amount of the equipment and its fair value are both $425,000 at the commencement date. The lease is not for a major part of the remaining economic life of the equipment, and the present value of the lease payments is not substantially all of the fair value of the equipment. Furthermore, title does not transfer to Lessee as a result of the lease, the lease does not contain an option for Lessee to purchase the underlying asset, and because the asset is nonspecialized, it is expected to have an alternative use to Lessor at the end of the lease term. Consequently, the lease is classified as an operating lease At the beginning of Year 3, Lessee and Lessor agree to extend the lease term by two years. That is, the modified lease is now a six-year lease, as compared with the original four-year lease. The additional two years were not an option when the original lease was negotiated. The modification alters the Lessee s right to use the equipment; it does not grant Lessee an additional right of use. Therefore, Lessor does not account for the modification as a separate contract from the original four-year lease contract On the effective date of the modification, the fair value of the equipment is $346,250, and the remaining economic life of the equipment is 5 years. The estimated residual value of the equipment is $35,000, of which none is guaranteed. The modified lease is for a major part of the remaining economic life of the equipment at the effective date of the modification (four years out of the five-year- remaining economic life of the equipment). Consequently, the modified lease is classified as a sales-type lease In accounting for the modification, Lessor determines the discount rate for the modified lease (that is, the rate implicit in the modified lease) to be 7.6 percent. Lessor recognizes the net investment in the modified lease of $346,250 and derecognizes both the accrued rent and the equipment at the effective date of the modification. Lessor also recognizes, in accordance with paragraph (b), selling profit of $34,169 ($320,139 lease receivable $8,510 accrued rent balance the $277,460 carrying amount of the equipment derecognized, net of the unguaranteed residual asset [$277,460 = $303,571 $26,111]). After the effective date of the modification, Lessor accounts for the modified lease in the same manner as any other sales-type lease in accordance with Subtopic Technical Line A closer look at the new leases standard 31 March 2016

136 ASC 842 includes the following example of a lessor s accounting for a modification to an operating lease that is not accounted for as a separate contract but changes lease classification (i.e., operating lease to direct financing lease). Implementation Guidance and Illustrations Example 21 Modification of an Operating Lease That Changes Lease Classification Case B Operating Lease to Direct Financing Lease At the beginning of Year 3, Lessee and Lessor enter into a modification to extend the lease term by 1 year, and Lessee agrees to make lease payments of $108,000 per year for each of the remaining 3 years of the modified lease. No other terms of the contract are modified. Concurrent with the execution of the modification, Lessor obtains a residual value guarantee from an unrelated third party for $40,000. Consistent with Case A (paragraphs through ), at the effective date of the modification the fair value of the equipment is $346,250, the carrying amount of the equipment is $303,571, and Lessor s accrued rent balance is $8,510. The estimated residual value at the end of the modified lease term is $80,000. The discount rate for the modified lease is percent Lessor reassesses the lease classification as of the effective date of the modification and concludes that the modified lease is a direct financing lease because none of the criteria in paragraph and both criteria in paragraph (b) are met Therefore, at the effective date of the modification, Lessor recognizes a net investment in the modified lease of $312,081, which is the fair value of the equipment ($346,250) less the selling profit on the lease ($34,169 =$313,922 lease receivable $8,510 accrued rent balance the $271,243 carrying amount of the equipment derecognized, net of the unguaranteed residual asset[$271,243 = $303,571 $32,328]), which is deferred as part of the net investment in the lease. After the effective date of the modification, Lessor accounts for the modified lease in the same manner as any other direct financing lease in accordance with Subtopic Modification to a direct financing lease that is not accounted for as a separate contract Leases Overall Recognition If a direct financing lease is modified and the modification is not accounted for as a separate contract in accordance with paragraph , the lessor shall account for the modified lease as follows: a. If the modified lease is classified as a direct financing lease, the lessor shall adjust the discount rate for the modified lease so that the initial net investment in the modified lease equals the carrying amount of the net investment in the original lease immediately before the effective date of the modification. b. If the modified lease is classified as a sales-type lease, the lessor shall account for the modified lease in accordance with the guidance applicable to sales-type leases in Subtopic , with the commencement date of the modified lease being the effective date of the modification. In calculating the selling profit or selling loss on the 136 Technical Line A closer look at the new leases standard 31 March 2016

137 lease, the fair value of the underlying asset is its fair value at the effective date of the modification and its carrying amount is the carrying amount of the net investment in the original lease immediately before the effective date of the modification. c. If the modified lease is classified as an operating lease, the carrying amount of the underlying asset equals the net investment in the original lease immediately before the effective date of the modification. Direct financing lease to direct financing lease If the original lease and the modified lease are both classified as direct financing leases (i.e., there is no change to lease classification), a lessor adjusts the discount rate used to measure the initial net investment in the modified lease so that it equals the carrying amount of the net investment in the original lease immediately before the effective date of the modification, plus any capitalized initial direct costs incurred in connection with the modification. No gain or loss is recognized unless there is an impairment of the net investment in the lease in which case a loss is recognized. Refer to section 5.2.3, Impairment of the net investment in the lease. Direct financing lease to sales-type lease If the modified lease is classified as a sales-type lease (i.e., lease classification changes), a lessor applies the initial recognition and measurement guidance for sales-type leases (refer to section 5.2.1, Initial recognition and measurement) and uses the fair value of the underlying asset and the carrying value of the net investment in the direct financing lease as of the effective date of the modification to calculate any gain or loss to be recognized in profit or loss. If the modification results in a sales-type lease with selling profit or loss, a lessor recognizes initial direct costs incurred in connection with the modification as an expense. Direct financing lease to operating lease If the modified lease is classified as an operating lease (i.e., lease classification changes), a lessor recognizes the carrying amount of the underlying asset at an amount equal to the net investment in the original lease immediately before the effective date of the modification. A lessor recognizes initial direct costs incurred in connection with the modification as an expense over the lease term. ASC 842 includes the following example of a lessor s accounting for a modification to a direct financing lease that is not accounted for as a separate contract and there is no change to lease classification. Implementation Guidance and Illustrations Example 22 Modification of a Direct Financing Lease Lessor enters into a six-year lease of a piece of new, nonspecialized equipment with a nine-year economic life. The annual lease payments are $11,000, payable in arrears. The estimated residual value of the equipment is $21,000, of which $15,000 is guaranteed by a third-party unrelated to Lessee or Lessor. The lease does not contain an option for Lessee to purchase the equipment and the title does not transfer to Lessee as a consequence of the lease. The fair value of the equipment at lease commencement is $65,240, which is equal to its cost (and carrying amount). Lessor incurs no initial direct costs in connection with the lease. The rate implicit in the lease is 7.5 percent such that the present value of the lease payments is $51,632 and does not amount to substantially all of the fair value of the equipment. 137 Technical Line A closer look at the new leases standard 31 March 2016

138 The Lessor concludes that the lease is not a sales-type lease because none of the criteria in paragraph are met. However, the sum of the present value of the lease payments and the present value of the residual value of the underlying asset guaranteed by the third-party guarantor is $61,352, which is substantially all of the fair value of the equipment, and collectibility of the lease payments is probable. Consequently, the lease is classified as a direct financing lease. Lessor recognizes the net investment in the lease of $65,240 (which includes the lease receivable of $61,352 and the present value of the unguaranteed residual value of $3,888 [the present value of the difference between the expected residual value of $21,000 and the guaranteed residual value of $15,000]) and derecognizes the equipment with a carrying amount of $65, At the end of Year 1, Lessor receives a lease payment of $11,000 from Lessee and recognizes interest income of $4,893 ($65, %). Therefore, the carrying amount of the net investment in the lease is $59,133 ($65,240 + $4,893 $11,000). Case A Direct Financing Lease to Direct Financing Lease At the end of Year 1, the lease term is reduced by 1 year and the annual lease payment is reduced to $10,000 for the remaining 4 years of the modified lease term. The estimated residual value of the equipment at the end of the modified lease term is $33,000, of which $30,000 is guaranteed by the unrelated third party, while the fair value of the equipment is $56,000. The remaining economic life of the equipment is 8 years and the present value of the remaining lease payments, discounted using the rate implicit in the modified lease of percent is $32,499. Lessor concludes that the modified lease is not a sales-type lease because none of the criteria in paragraph are met. However, the sum of the present value of the lease payments and the present value of the residual value of the underlying asset guaranteed by the third-party guarantor, discounted using the rate implicit in the modified lease of percent, is $53,864, which is substantially all of the fair value of the equipment, and collectibility of the lease payments is probable. As such, the modified lease is classified as a direct financing lease In accounting for the modification in accordance with paragraph (a), Lessor carries forward the balance of the net investment in the lease of $59,133 immediately before the effective date of the modification as the opening balance of the net investment in the modified lease. To retain the same net investment in the lease even while the lease payments, the lease term, and the estimated residual value have all changed, Lessor adjusts the discount rate for the lease from the rate implicit in the modified lease of percent to 6.95 percent. This discount rate is used to calculate interest income on the net investment in the lease throughout the remaining term of the modified lease and will result, at the end of the modified lease term, in a net investment balance that equals the estimated residual value of the underlying asset of $33,000. ASC 842 includes the following example of a lessor s accounting for a modification to a direct financing lease that is not accounted for as a separate contract but changes lease classification. This example assumes the same facts as in Case A above, except that the modified lease is classified as a sales-type lease. 138 Technical Line A closer look at the new leases standard 31 March 2016

139 Case B Direct Financing Lease to Sales-Type Lease At the end of Year 1, the lease term is extended for two years. The lease payments remain $11,000 annually, paid in arrears, for the remainder of the lease term. The estimated residual value is $6,500, of which none is guaranteed. The rate implicit in the modified lease is 7.58 percent. At the effective date of the modification, the remaining economic life of the equipment is 8 years and the fair value of the equipment is $62,000. Because the modified lease term is now for the major part of the remaining economic life of the equipment, the modified lease is classified as a sales-type lease On the effective date of the modification, Lessor recognizes a net investment in the sales-type lease of $62,000, which is equal to the fair value of the equipment at the effective date of the modification, and derecognizes the carrying amount of the net investment in the original direct financing lease of $59,133. The difference of $2,867 is the selling profit on the modified lease. After the effective date of the modification, Lessor accounts for the sales-type lease in the same manner as any other sales-type lease in accordance with Subtopic ASC 842 includes the following example of a lessor s accounting for a modification to a direct financing lease that is not accounted for as a separate contract but changes lease classification. This example assumes the same facts as in Case A above, except that the modified lease is classified as an operating lease. Case C Direct Financing Lease to Operating Lease At the end of Year 1, the lease term is reduced by 2 years, and the lease payments are reduced to $9,000 per year for the remaining 3-year lease term. The estimated residual value is revised to $33,000, of which only $13,000 is guaranteed by an unrelated third party. The fair value of the equipment at the effective date of the modification is $56,000. The modified lease does not transfer the title of the equipment to Lessee or grant Lessee an option to purchase the equipment. The modified lease is classified as an operating lease because it does not meet any of the criteria to be classified as a sales-type lease or as a direct financing lease Therefore, at the effective date of the modification, Lessor derecognizes the net investment in the lease, which has a carrying amount of $59,133, and recognizes the equipment at that amount. Collectibility of the lease payments is probable; therefore, Lessor will recognize the $27,000 ($9,000 3 years) in lease payments on a straight-line basis over the 3-year modified lease term, as well as depreciation on the rerecognized equipment. 139 Technical Line A closer look at the new leases standard 31 March 2016

140 Modification to a sales-type lease that is not accounted for as a separate contract Leases Overall Recognition If a sales-type lease is modified and the modification is not accounted for as a separate contract in accordance with paragraph , the lessor shall account for the modified lease as follows: a. If the modified lease is classified as a sales-type or a direct financing lease, in the same manner as described in paragraph (a) b. If the modified lease is classified as an operating lease, in the same manner as described in paragraph (c). Sales-type lease to sales-type lease or to direct financing lease If the modified lease is classified as a sales-type lease (i.e., there is no change to lease classification) or a direct financing lease (i.e., there is a change to lease classification), a lessor adjusts the discount rate used to measure the initial net investment in the modified lease so that it equals the carrying amount of its net investment in the original lease immediately before the effective date of the modification plus any capitalized initial direct costs incurred in connection with the modification. No gain or loss is recognized unless there is an impairment of the net investment in the lease in which case a loss is recognized. Refer to section 5.2.3, Impairment of the net investment in the lease. Lessors are prohibited from recognizing a second gain on a sales-type lease that is modified and remains a sales-type lease. Sales-type lease to operating lease If the modified lease is classified as an operating lease (i.e., lease classification changes), a lessor recognizes the carrying amount of the underlying asset at an amount equal to the net investment in the original lease immediately before the effective date of the modification. A lessor recognizes initial direct costs incurred in connection with the modification as an expense over the lease term. 5.7 Other lessor matters Sale of lease receivables Leases Lessor Subsequent Measurement If a lessor sells the lease receivable associated with a sales-type lease or a direct financing lease and retains an interest in the unguaranteed residual asset, the lessor shall not continue to accrete the unguaranteed residual asset to its estimated value over the remaining lease term. The lessor shall report any remaining unguaranteed residual asset thereafter at its carrying amount at the date of the sale of the lease receivable and apply Topic 360 on property, plant, and equipment to determine whether the unguaranteed residual asset is impaired. 140 Technical Line A closer look at the new leases standard 31 March 2016

141 In certain cases, a lessor sells a lease receivable (i.e., the future lease payments and any guaranteed residual value) associated with a sales-type or a direct financing lease but retains an interest in the unguaranteed residual asset. In a common transaction, a lessor securitizes lease receivables, retains the interest in the underlying assets (i.e., the unguaranteed residual assets) and manages the residual value risk. Under ASC 842, if a lessor retains an interest in an unguaranteed residual asset, it no longer accretes the value of that asset to its estimated value over the remaining lease term. Instead, the lessor reports any remaining unguaranteed residual asset at its carrying amount at the date of the sale of the lease receivable and applies ASC 360 to determine whether the unguaranteed residual asset is impaired. Lessors should evaluate the sale of lease receivables associated with sales-type or direct financing leases (i.e., future lease payments and any guaranteed residual values) under the financial asset derecognition guidance in ASC 860, Transfers and Servicing Accounting for the underlying asset at the end of a lease Leases Lessor Subsequent Measurement At the end of the lease term, a lessor shall reclassify the net investment in the lease to the appropriate category of asset (for example, property, plant, and equipment) in accordance with other Topics, measured at the carrying amount of the net investment in the lease. The lessor shall account for the underlying asset that was the subject of a lease in accordance with other Topics. At the end of the lease term, lessors may receive the underlying asset back from the lessee. Under ASC 842, lessors reclassify the carrying amount of the net investment in the lease to the applicable category of assets (i.e., property, plant and equipment). Thereafter, lessors account for the underlying asset using ASC Lease termination Leases Lessor Derecognition If a sales-type lease or a direct financing lease is terminated before the end of the lease term, a lessor shall do all of the following: a. Test the net investment in the lease for impairment in accordance with Topic 310 on receivables and recognize any impairment loss identified b. Reclassify the net investment in the lease to the appropriate category of asset in accordance with other Topics, measured at the sum of the carrying amounts of the lease receivable (less any amounts still expected to be received by the lessor) and the residual asset c. Account for the underlying asset that was the subject of the lease in accordance with other Topics. 141 Technical Line A closer look at the new leases standard 31 March 2016

142 For a termination of a sales-type or direct financing lease before the expiration of the lease term, a lessor does the following: Tests the net investment in the lease for impairment in accordance with ASC 310 and recognizes any impairment loss identified (refer to section 5.2.3, Impairment of the net investment in the lease) Reclassifies the net investment in the lease to the appropriate category of asset in accordance with ASC 360, measured at the sum of the carrying amount of the lease receivable (less any amounts still expected to be received by the lessor) and the residual asset Accounts for the underlying asset that was the subject of the lease under ASC Portfolio approach ASC 842 applies to individual leases. However, entities that have a large number of leases of similar assets (e.g., leases of a fleet of similar rail cars) may face practical challenges in applying the leases model on a lease by lease basis. The FASB acknowledged these concerns and said in its Basis for Conclusions (BC 120) that an entity can use a portfolio approach when the entity reasonably expects that the application of the leases model to the portfolio would not differ materially from the application of the leases model to the individual leases in that portfolio. For example, applying a portfolio approach to four-year leases of fungible, new rail cars entered into in the same month with lessees of a similar credit quality may not differ materially from applying ASC 842 to the individual leases in the portfolio. ASC 842 does not define reasonably expects and materially. The FASB also said in the Basis for Conclusions (BC 120) that an entity would need to apply judgment in selecting the size and composition of the portfolio and it did not intend for an entity to quantitatively evaluate each outcome but, instead, that the entity should be able to take a reasonable approach to determine the portfolios that would be appropriate for its types of leases. The FASB also said in the Basis for Conclusions (BC 121) that the cost relief offered by applying the leases guidance at a portfolio level need not be limited to simply grouping contracts together. The portfolio approach could also be applied to other aspects of the leases guidance for which lessors need to make judgments and estimates, such as determining the discount rate and determining and reassessing the lease term Leveraged leases Master Glossary Leveraged Lease From the perspective of a lessor, a lease that was classified as a leveraged lease in accordance with the leases guidance in effect before the effective date and for which the commencement date is before the effective date. Leases Overall Transition and Open Effective Date Information Leases previously classified as leveraged leases under Topic 840 z. For leases that were classified as leveraged leases in accordance with Topic 840, and for which the commencement date is before the effective date, a lessor shall apply the requirements in Subtopic If a leveraged lease is modified on or after the effective date, it shall be accounted for as a new lease as of the effective date of the modification in accordance with the guidance in Subtopics and Technical Line A closer look at the new leases standard 31 March 2016

143 1. A lessor shall apply the pending content that links to this paragraph to a leveraged lease that meets the criteria in (z) that is acquired in a business combination or an acquisition by a not-for-profit entity on or after the effective date. Leases Leveraged Lease Arrangements Scope and Scope Exceptions This Subtopic addresses accounting for leases that meet the criteria in transition paragraph (z). If a lessee exercises an option to extend a lease that meets the criteria in transition paragraph (z) that it was not previously reasonably assured of exercising, the exercise of that option shall be considered a lease modification as described in paragraph (z). ASU eliminates leveraged lease accounting for new leases on its effective date. That is, subsequent to the effective date lessors account for all new leases, including those that would have qualified as leveraged leases under ASC 840, using the classifications discussed in section 3.2, Criteria for lease classification lessors (i.e., sales-type, direct financing or operating). For such leases, entities apply other relevant US GAAP (e.g., ASC 740, Income Taxes, ASC 470, Debt) to account for the non-lease components of such transactions. ASU eliminates leveraged lease accounting for new leases on its effective date. Leveraged lease arrangements that exist before the effective date are grandfathered and therefore continue to follow the existing recognition, measurement, presentation and disclosure guidance for leveraged leases that was carried forward to ASC 842. Leases of to-be-constructed assets that qualified to be leveraged leases at lease inception prior to the effective date under ASC 840 but are not completed (i.e. the lease has not commenced) prior to the effective date would not be grandfathered. If an existing leveraged lease is modified on or after the effective date of the new standard, the existing leveraged lease is required to be reclassified as a sales-type, direct financing or operating lease, as applicable, using the lease classification guidance in ASC 842. Refer to section 3.2, Criteria for lease classification lessors, and section 9.2, Transition. In that case, there would be no basis to net the remaining non-recourse debt balance with the lease receivable, and any deferred tax balances would need to be adjusted as required under ASC 740 to comply with that guidance. In addition, if a lessee exercises an option to extend a leveraged lease on or after the effective date of the new standard that it was not previously reasonably assured of exercising, the exercise of that option is accounted for as a lease modification, and the lease no longer qualifies for leveraged lease accounting. Refer to section 5.6, Lease modifications. Refer to our Financial reporting developments publication, Lease accounting, for an in-depth discussion of the accounting for leveraged leases Income tax accounting ASC 842 could affect lessors accounting for income taxes. Applying ASC 842 could change the recognition of lease-related assets (i.e., lease receivables and any unguaranteed residual assets), the measurement of lease-related assets and the derecognition of underlying assets for certain leases that are subject to operating leases under ASC 840. ASC 842 also changes the timing of recognition of lease income for some leases. In addition, the special accounting for leveraged leases is eliminated, except for leveraged leases that exist at the transition date, which are grandfathered (refer to section 5.7.5, Leveraged leases). 143 Technical Line A closer look at the new leases standard 31 March 2016

144 These changes could affect certain aspects of accounting for income taxes, such as the following: Recognition and measurement of deferred tax assets and liabilities Assessment of the recoverability of deferred tax assets (i.e., the need for and measurement of valuation allowances) Refer to our Financial reporting developments publication, Income taxes. 5.8 Presentation Leases Lessor Other Presentation Matters Sales-Type and Direct Financing Leases Statement of Financial Position A lessor shall present lease assets (that is, the aggregate of the lessor s net investment in sales-type leases and direct financing leases) separately from other assets in the statement of financial position Lease assets shall be subject to the same considerations as other assets in classification as current or noncurrent assets in a classified balance sheet. Statement of Comprehensive Income A lessor shall either present in the statement of comprehensive income or disclose in the notes income arising from leases. If a lessor does not separately present lease income in the statement of comprehensive income, the lessor shall disclose which line items include lease income in the statement of comprehensive income A lessor shall present any profit or loss on the lease recognized at the commencement date in a manner that best reflects the lessor s business model(s). Examples of presentation include the following: a. If a lessor uses leases as an alternative means of realizing value from the goods that it would otherwise sell, the lessor shall present revenue and cost of goods sold relating to its leasing activities in separate line items so that income and expenses from sold and leased items are presented consistently. Revenue recognized is the lesser of: 1. The fair value of the underlying asset at the commencement date 2. The sum of the lease receivable and any lease payments prepaid by the lessee. Cost of goods sold is the carrying amount of the underlying asset at the commencement date minus the unguaranteed residual asset. b. If a lessor uses leases for the purposes of providing finance, the lessor shall present the profit or loss in a single line item. 144 Technical Line A closer look at the new leases standard 31 March 2016

145 Statement of Cash Flows In the statement of cash flows, a lessor shall classify cash receipts from leases within operating activities. Operating Leases Statement of Financial Position A lessor shall present the underlying asset subject to an operating lease in accordance with other Topics. Statement of Cash Flows In the statement of cash flows, a lessor shall classify cash receipts from leases within operating activities. The table below summarizes how lease-related amounts and activities are presented in lessors financial statements: Financial statement Balance sheet Income statement Statement of cash flows Lessor presentation Sales-type and direct financing leases: The net investment in the lease is presented separately from other assets. The net investment in the lease is subject to the same considerations as other assets in classification as current or noncurrent assets in a classified balance sheet. Operating leases: Underlying assets are presented in accordance with applicable guidance. All leases: Income arising from leases is presented separately from other activity, or disclosed in the notes (along with the corresponding line item(s) in the income statement). Sales-type leases and direct financing leases: Profit (for sales-type leases) or loss (for sales-type and direct financing leases) recognized at the commencement date is presented on either a gross or net basis, based on the lessor s business model. For example, lessors that use leasing as an alternative means to realize value from goods they would otherwise sell present lease revenue and cost of goods sold on a gross basis (i.e., revenue and cost of goods sold in separate line items). For example, lessors that use leases for the purpose of providing financing present the profit or loss on a net basis (i.e., in a single line item). All leases: Cash lease payments received are presented within operating activities. 145 Technical Line A closer look at the new leases standard 31 March 2016

146 5.9 Disclosure The objective of lessor disclosures is to enable financial statement users to assess the amount, timing and uncertainty of lease-related cash flows. ASC 842 requires a lessor to disclose quantitative and qualitative information about its leases, the significant judgments made in applying ASC 842 and the amounts recognized in the financial statements related to those leases. Lessors may need to exercise judgment to determine the appropriate level at which to aggregate or disaggregate disclosures so that meaningful information is not obscured by insignificant details or by grouping items with different characteristics. The disclosure requirements apply to both public and nonpublic entities. ASC 842 includes the following disclosure requirements for lessors: Leases Lessor Disclosure A lessor shall disclose both of the following: a. Information about the nature of its leases, including: Lessors are required to disclose more information about how they manage the risks related to residual values of assets under lease. 1. A general description of those leases 2. The basis and terms and conditions on which variable lease payments are determined 3. The existence and terms and conditions of options to extend or terminate the lease 4. The existence and terms and conditions of options for a lessee to purchase the underlying asset. b. Information about significant assumptions and judgments made in applying the requirements of this Topic, which may include the following: 1. The determination of whether a contract contains a lease (as described in paragraphs through 15-27) 2. The allocation of the consideration in a contract between lease and nonlease components (as described in paragraphs through 15-32) 3. The determination of the amount the lessor expects to derive from the underlying asset following the end of the lease term A lessor shall disclose any lease transactions between related parties (see Topic 850 on related party disclosures) A lessor shall disclose lease income recognized in each annual and interim reporting period, in a tabular format, to include the following: a. For sales-type leases and direct financing leases: 1. Profit or loss recognized at the commencement date (disclosed on a gross basis or a net basis consistent with paragraph ) 2. Interest income either in aggregate or separated by components of the net investment in the lease. 146 Technical Line A closer look at the new leases standard 31 March 2016

147 b. For operating leases, lease income relating to lease payments. c. Lease income relating to variable lease payments not included in the measurement of the lease receivable A lessor shall disclose in the notes the components of its aggregate net investment in sales-type and direct financing leases (that is, the carrying amount of its lease receivables, its unguaranteed residual assets, and any deferred selling profit on direct financing leases) A lessor shall disclose information about how it manages its risk associated with the residual value of its leased assets. In particular, a lessor should disclose all of the following: a. Its risk management strategy for residual assets b. The carrying amount of residual assets covered by residual value guarantees (excluding guarantees considered to be lease payments for the lessor, as described in paragraph (a)(2)) c. Any other means by which the lessor reduces its residual asset risk (for example, buyback agreements or variable lease payments for use in excess of specified limits). Sales-Type and Direct Financing Leases In addition to the disclosures required by paragraphs through 50-7, a lessor also shall provide the disclosures in paragraphs through for sales-type leases and direct financing leases A lessor shall explain significant changes in the balance of its unguaranteed residual assets and deferred selling profit on direct financing leases A lessor shall disclose a maturity analysis of its lease receivables, showing the undiscounted cash flows to be received on an annual basis for a minimum of each of the first five years and a total of the amounts for the remaining years. A lessor shall disclose a reconciliation of the undiscounted cash flows to the lease receivables recognized in the statement of financial position (or disclosed separately in the notes). Operating Leases In addition to the disclosures required by paragraphs through 50-7, a lessor also shall provide the disclosures in paragraphs through for operating leases A lessor shall disclose a maturity analysis of lease payments, showing the undiscounted cash flows to be received on an annual basis for a minimum of each of the first five years and a total of the amounts for the remaining years. A lessor shall present that maturity analysis separately from the maturity analysis required by paragraph for sales-type leases and direct financing leases A lessor shall provide disclosures required by Topic 360 on property, plant, and equipment separately for underlying assets under operating leases from owned assets. 147 Technical Line A closer look at the new leases standard 31 March 2016

148 6 Subleases 6.1 Definition Master Glossary Sublease A transaction in which an underlying asset is re-leased by the lessee (or intermediate lessor) to a third party (the sublessee) and the original (or head) lease between the lessor and the lessee remains in effect. Lessees often enter into arrangements to sublease a leased asset to a third party while the original lease contract is in effect. In these arrangements, one party acts as both the lessee and lessor of the same underlying asset. The original lease is often referred to as a head lease, the original lessee is often referred to as an intermediate lessor or sublessor, and the ultimate lessee is often referred to as the sublessee. Lessor Head lease Original lessee/sublessor Sublease Lessee/sublessee In some cases, the sublease is a separate lease agreement. In other cases, a third party assumes the original lease, but the original lessee remains the primary obligor under the original lease The original lessee is relieved of the primary obligation not a sublease Leases Overall Derecognition If the nature of a sublease is such that the original lessee is relieved of the primary obligation under the original lease, the transaction shall be considered a termination of the original lease. Paragraph addresses subleases in which the original lessee is not relieved of the primary obligation under the original lease. Any consideration paid or received upon termination that was not already included in the lease payments (for example, a termination payment that was not included in the lease payments based on the lease term) shall be included in the determination of profit or loss to be recognized in accordance with paragraph If a sublease is a termination of the original lease and the original lessee is secondarily liable, the guarantee obligation shall be recognized by the lessee in accordance with paragraph Technical Line A closer look at the new leases standard 31 March 2016

149 If the original lessee is relieved of the primary obligation under the original lease, the transaction is not a sublease. Such transactions are considered a termination (refer to section 4.6.3, Lease termination) of the original lease, and the lease-related assets and obligations are derecognized. Any consideration paid or received upon termination that was not already included in the lease payments (e.g., a termination penalty that was not included in lease payments based on the lease term) is included in the gain or loss on termination of the original lease. If the original lessee remains secondarily liable for the original lease, the guarantee obligation is recognized by the lessee in accordance with ASC (i.e., measured at fair value and included in the determination of gain or loss on lease termination). 6.2 Original lessor accounting Leases Lessor Subsequent Measurement If the original lessee enters into a sublease or the original lease agreement is sold or transferred by the original lessee to a third party, the original lessor shall continue to account for the lease as it did before. Derecognition If the original lease agreement is replaced by a new agreement with a new lessee, the lessor shall account for the termination of the original lease as provided in paragraph and shall classify and account for the new lease as a separate transaction. If the original lessee enters into a sublease or sells or transfers the original lease to a third party, the original lessor does not change its accounting for the original lease. However, if the original lease agreement is replaced by a new agreement with a new lessee, the original lessor accounts for both the termination of the original lease and the new lease, which is a separate transaction. Refer to section 5.7.3, Lease termination. 6.3 Sublessor accounting Leases Overall Recognition When classifying a sublease, an entity shall classify the sublease with reference to the underlying asset (for example, the item of property, plant, or equipment that is the subject of the lease) rather than with reference to the right-of-use asset. 149 Technical Line A closer look at the new leases standard 31 March 2016

150 Subsequent Measurement If the nature of a sublease is such that the original lessee is not relieved of the primary obligation under the original lease, the original lessee (as sublessor) shall continue to account for the original lease in one of the following ways: a. If the sublease is classified as an operating lease, the original lessee shall continue to account for the original lease as it did before commencement of the sublease. If the lease cost for the term of the sublease exceeds the anticipated sublease income for that same period, the original lessee shall treat that circumstance as an indicator that the carrying amount of the right-of-use asset associated with the original lease may not be recoverable in accordance with paragraph Classification of a sublease is based on the underlying asset, not the right-of-use asset. b. If the original lease is classified as a finance lease and the sublease is classified as a sales-type lease or a direct financing lease, the original lessee shall derecognize the original right-of-use asset in accordance with paragraph and continue to account for the original lease liability as it did before commencement of the sublease. The original lessee shall evaluate its investment in the sublease for impairment in accordance with paragraph c. If the original lease is classified as an operating lease and the sublease is classified as a sales-type lease or a direct financing lease, the original lessee shall derecognize the original right-of-use asset in accordance with paragraph and, from the sublease commencement date, account for the original lease liability in accordance with paragraphs through The original lessee shall evaluate its investment in the sublease for impairment in accordance with paragraph The original lessee (as sublessor) in a sublease shall use the rate implicit in the lease to determine the classification of the sublease and to measure the net investment in the sublease if the sublease is classified as a sales-type or a direct financing lease unless that rate cannot be readily determined. If the rate implicit in the lease cannot be readily determined, the original lessee may use the discount rate for the lease established for the original (or head) lease. If an underlying asset is re-leased by a lessee to a third party and the original lessee retains the primary obligation under the original lease, the transaction is a sublease. A sublessor assesses sublease classification independently of the classification assessment that it made as the lessee of the same asset. A sublessor considers the lease classification criteria in section 3.2, Criteria for lease classification lessors, with reference to the underlying asset when classifying a sublease (e.g., the underlying asset subject to the sublease) rather than the right-of-use asset recognized as part of the head lease. A sublessor uses the rate implicit in the lease (i.e., the rate implicit in the sublease) to determine the classification of the sublease and to measure the net investment in a sublease that is classified as a sales-type or a direct financing lease. If the rate implicit in the lease cannot be readily determined, the sublessor uses the discount rate for the lease established for the head lease. Refer to section 3.4.8, Classification of subleases, and section 2.5, Discount rates. 150 Technical Line A closer look at the new leases standard 31 March 2016

151 The following table summarizes how the original lessee/sublessor accounts for the head lease and sublease at the commencement of the sublease. Head lease finance lease Head lease operating lease Sublease sales-type or direct financing lease The original lessee derecognizes the original right-of-use asset and continues to account for the original lease liability as it did before the commencement of the sublease (i.e., in accordance with the finance lease provisions of the lessee accounting guidance). The original lessee, as the sublessor, recognizes a net investment in the sublease and evaluates it for impairment under ASC 310. Refer to section 5.2.3, Impairment of the net investment in the lease. The original lessee derecognizes the original right-of-use asset at the sublease commencement date and accounts for the original lease liability in accordance with the finance lease provisions of the lessee accounting guidance. The original lessee, as the sublessor, recognizes a net investment in the sublease and evaluates it for impairment under ASC 310. Refer to section 5.2.3, Impairment of the net investment in the lease. Sublease operating lease The original lessee continues to account for head lease as it did before the commencement date of the sublease (i.e., in accordance with the lessee accounting guidance). If the lease cost for the term of the sublease exceeds the anticipated sublease income (as the sublessor) for the same period, this may indicate that the right-of-use asset associated with the head lease should be assessed for impairment under the long-lived asset impairment provisions of ASC 360. How we see it While not addressed in ASC 842, we believe that when a sublease is classified as a sales-type lease, any selling profit is recognized at the sublease commencement date. When a sublease is classified as a sales-type or direct financing lease, we believe that any selling loss is recognized at the inception of the sublease (i.e., selling loss is not deferred). 6.4 Sublessee accounting A sublessee accounts for a sublease in the same manner as any other lease (i.e., as a new lease subject to ASC 842 s recognition and measurement provisions). Refer to chapter 4, Lessee accounting. A sublessee classifies the sublease by referring to the underlying asset rather than by referring to the right-of-use asset arising from the head lease. 6.5 Disclosure In addition to making other lessor disclosures (refer to section 5.9, Disclosure), ASC 842 requires an original lessee/sublessor to disclose (1) the existence, and terms and conditions, of residual value guarantees provided by the sublessee and (2) sublease income, on a gross basis, separate from the finance or operating lease expense. 151 Technical Line A closer look at the new leases standard 31 March 2016

152 Sale and leaseback transactions no longer provide lessees with a source of off-balance sheet financing. 7 Sale and leaseback transactions Leases Sale and Leaseback Transactions Scope and Scope Exceptions If an entity (the seller-lessee) transfers an asset to another entity (the buyer-lessor) and leases that asset back from the buyer-lessor, both the seller-lessee and the buyer-lessor shall account for the transfer contract and the lease in accordance with Sections , , and A sale and leaseback transaction involves the transfer of an asset by an entity (the seller-lessee) to another entity (the buyer-lessor) and the leaseback of the same asset by the seller-lessee. Because ASC 842 requires lessees to recognize most leases on their balance sheets (i.e., all leases except for short-term leases if the lessee makes an accounting policy election to use this exception), sale and leaseback transactions no longer provide lessees with a source of off-balance sheet financing. Another key change is that both the seller-lessee and the buyer-lessor are required to apply ASC 842 and ASC 606 to determine whether to account for a sale and leaseback transaction as a sale and purchase of an asset. Finally, ASC 842 s guidance on sale and leaseback transactions applies to all assets that are within the scope of ASC 842. That is, unlike ASC 840, ASC 842 doesn t provide any specific guidance for sale and leaseback transactions involving real estate. 7.1 Determining whether the transfer of an asset is a sale Leases Sale and Leaseback Transactions Recognition An entity shall apply the following requirements in Topic 606 on revenue from contracts with customers when determining whether the transfer of an asset shall be accounted for as a sale of the asset: a. Paragraphs through 25-8 on the existence of a contract b. Paragraph on when an entity satisfies a performance obligation by transferring control of an asset The existence of a leaseback (that is, a seller-lessee s right to use the underlying asset for a period of time) does not, in isolation, prevent the buyer-lessor from obtaining control of the asset. However, the buyer-lessor is not considered to have obtained control of the asset in accordance with the guidance on when an entity satisfies a performance obligation by transferring control of an asset in Topic 606 if the leaseback would be classified as a finance lease or a sales-type lease An option for the seller-lessee to repurchase the asset would preclude accounting for the transfer of the asset as a sale of the asset unless both of the following criteria are met: a. The exercise price of the option is the fair value of the asset at the time the option is exercised. b. There are alternative assets, substantially the same as the transferred asset, readily available in the marketplace. 152 Technical Line A closer look at the new leases standard 31 March 2016

153 Unlike other buyers of assets, a buyer in a sale and leaseback transaction will determine whether it has purchased an asset by applying the new revenue guidance. When determining whether the transfer of an asset should be accounted for as a sale and purchase, both the seller-lessee and the buyer-lessor apply the guidance in (1) ASC through 25-8 on the existence of a contract, (2) ASC on when an entity satisfies a performance obligation by transferring control of an asset and (3) ASC through Refer to chapter 3, Identifying the contract with the customer, of our Financial reporting developments publication, Revenue from contracts with customers (ASC 606), for an in-depth discussion of identifying the contract with the customer and section 7.2, Control transferred at a point in time, of that publication for a discussion of transferring control at a point in time. ASC 842 also includes guidance for evaluating whether the transfer of an asset with a leaseback to the seller is a sale and purchase. Under this guidance, the existence of the leaseback, in and of itself, does not preclude a sale and purchase. However, a sale and a purchase does not occur if the leaseback would be classified as a finance lease (lessee) or a sales-type lease (lessor). In these types of leases, the FASB believes that the seller-lessee effectively retains control of the underlying asset. Therefore, the FASB indicated in the Basis for Conclusions (BC 352(b)) that it is inappropriate for a seller-lessee to account for the sale of an underlying asset that it concurrently repurchases. Instead, these transactions are accounted for as financings by both the buyer-lessor (lender) and the seller-lessee (borrower). While an option for a seller-lessee to repurchase the transferred asset generally precludes sale accounting under ASC 606, ASC 842 specifies that an option for the seller-lessee to repurchase the asset does not preclude sale and purchase accounting when both of the following conditions are met: The exercise price of the option is the fair value of the underlying asset at the time the option is exercised. There are alternative assets, substantially the same as the transferred asset, readily available in the marketplace. The FASB observed in the Basis for Conclusions (BC 352(c)) that a real estate asset generally is not considered substantially the same as any other real estate asset because real estate is, by its nature, unique. 7.2 Transactions in which the transfer of an asset is a sale Leases Sale and Leaseback Transactions Recognition If the transfer of the asset is a sale in accordance with paragraphs through 25-3, both of the following apply: a. The seller-lessee shall: 1. Recognize the transaction price for the sale at the point in time the buyer-lessor obtains control of the asset in accordance with paragraph in accordance with the guidance on determining the transaction price in paragraphs through Derecognize the carrying amount of the underlying asset 3. Account for the lease in accordance with Subtopic b. The buyer-lessor shall account for the purchase in accordance with other Topics and for the lease in accordance with Subtopic Technical Line A closer look at the new leases standard 31 March 2016

154 Initial Measurement An entity shall determine whether a sale and leaseback transaction is at fair value on the basis of the difference between either of the following, whichever is more readily determinable: a. The sale price of the asset and the fair value of the asset b. The present value of the lease payments and the present value of market rental payments If the sale and leaseback transaction is not at fair value, the entity shall adjust the sale price of the asset on the same basis the entity used to determine that the transaction was not at fair value in accordance with paragraph The entity shall account for both of the following: a. Any increase to the sale price of the asset as a prepayment of rent b. Any reduction of the sale price of the asset as additional financing provided by the buyer-lessor to the seller-lessee. The seller-lessee and the buyer-lessor shall account for the additional financing in accordance with other Topics A sale and leaseback transaction is not off market solely because the sale price or the lease payments include a variable component. In determining whether the sale and leaseback transaction is at fair value, the entity should consider those variable payments it reasonably expects to be entitled to (or to make) on the basis of all of the information (historical, current, and forecast) that is reasonably available to the entity. For a seller-lessee, this would include estimating any variable consideration to which it expects to be entitled in accordance with paragraphs through If the transaction is a related party lease, an entity shall not make the adjustments required in paragraph , but shall provide the required disclosures as discussed in paragraphs and If the transfer of the asset is a sale, the seller-lessee does each of the following: Recognizes the transaction price for the sale in accordance with the guidance on determining the transaction price in ASC through at the point in time that the buyer-lessor obtains control of the asset (refer to chapter 5, Determine the transaction price, of our Financial reporting developments publication, Revenue from contracts with customers (ASC 606), for an in-depth discussion of determining the transaction price) Derecognizes the carrying amount of the underlying asset Recognizes any gain or loss, adjusted for off-market terms, immediately (refer to section 7.2.2, Adjustment for off-market terms) A buyer-lessor accounts for the purchase of the asset in accordance with ASC Accounting for the leaseback When a sale occurs, both the seller-lessee and the buyer-lessor account for the leaseback in the same manner as any other lease (i.e., in accordance with the lessee and lessor guidance, respectively), with adjustments for any off-market terms. 154 Technical Line A closer look at the new leases standard 31 March 2016

155 An adjustment for off-market terms should not be made for a related party lease Adjustment for off-market terms A sale transaction and the ensuing lease are generally interdependent and negotiated as a package. Consequently, some transactions could be structured with a negotiated sale price that is above or below the asset s fair value and with lease payments for the ensuing lease that are above or below the then-current market rates. These off-market terms could distort the gain or loss on the sale and the recognition of lease expense and lease income for the lease. To make sure that the gain or loss on the sale and the lease-related assets and liabilities associated with such transactions are not understated or overstated, ASC 842 requires adjustments for any off-market terms of sale and leaseback transactions. The off-market adjustments are based on the difference between (1) the sale price of the asset and its fair value or (2) the present value of the lease payments and the present value of market rental payments, whichever is more readily determinable. The FASB indicated in the Basis for Conclusions (BC 364) that entities are expected to maximize the use of observable prices and information when determining which measure is the most appropriate to use. When the sale price is less than the underlying asset s fair value or the present value of the lease payments is less than the present value of market rental payments, a seller-lessee recognizes the difference as an increase to the sales price and the initial measurement of the right-of-use asset as a lease prepayment. When the sale price is greater than the underlying asset s fair value or the present value of the lease payments is greater than the present value of market rental payments, a seller-lessee recognizes the difference as a reduction to the sales price and an additional financing received from the buyer-lessor separately from the lease liability. The seller-lessee accounts for the additional financing in accordance with other US GAAP. Buyer-lessors are also required to adjust the purchase price of the underlying asset for any off-market terms. Such adjustments are recognized as lease prepayments made by the seller-lessee or as additional financing provided to the seller-lessee. The buyer-lessor accounts for any additional financing in accordance with other US GAAP Variable lease payments The terms of a sale and leaseback transaction are not off market solely because the sale price or the lease payments include a variable component. In determining whether the sale and leaseback transaction is at fair value, an entity should consider variable payments it reasonably expects to be entitled to (or to make) on the basis of all of the information (i.e., historical, current and forecasted) that is reasonably available. For a seller-lessee, this includes estimating any variable consideration it expects to be entitled to in accordance with ASC through Refer to section 5.1, Variable consideration, of our Financial reporting developments publications, Revenue from contracts with customers (ASC 606), for an in-depth discussion of estimating variable consideration Related party leasing transactions Adjustments are not made to reflect either the fair value of the purchase and sale or the current market rates for a lease in sale and leaseback transactions among related parties. Refer to section 2.9, Related party leasing transactions. How we see it We generally expect more real estate sale and leaseback transactions to be accounted for as sales and leasebacks under ASC 842 than under ASC 840 due to the elimination of the real estate-specific requirements in today s sale and leaseback accounting guidance. 155 Technical Line A closer look at the new leases standard 31 March 2016

156 7.2.3 Example ASC 842 provides the following example of the accounting for a sale and leaseback transaction. Leases Sale and Leaseback Transactions Implementation Guidance and Illustrations Example 1 Sale and Leaseback Transaction An entity (Seller) sells a piece of land to an unrelated entity (Buyer) for cash of $2 million. Immediately before the transaction, the land has a carrying amount of $1 million. At the same time, Seller enters into a contract with Buyer for the right to use the land for 10 years (the leaseback), with annual payments of $120,000 payable in arrears. This Example ignores any initial direct costs associated with the transaction. The terms and conditions of the transaction are such that Buyer obtains substantially all the remaining benefits of the land on the basis of the combination of the cash flows it will receive from Seller during the leaseback and the benefits that will be derived from the land at the end of the lease term. In determining that a sale occurs at commencement of the leaseback, Seller considers that, at that date, all of the following apply: a. Seller has a present right to payment of the sales price of $2 million. b. Buyer obtains legal title to the land. c. Buyer has the significant risks and rewards of ownership of the land because, for example, Buyer has the ability to sell the land if the property value increases and also must absorb any losses, realized or unrealized, if the property value declines The observable fair value of the land at the date of sale is $1.4 million. Because the fair value of the land is observable, both Seller and Buyer utilize that benchmark in evaluating whether the sale is at market term. Because the sale is not at fair value (that is, the sales price is significantly in excess of the fair value of the land), both Seller and Buyer adjust for the off-market terms in accounting for the transaction. Seller recognizes a gain of $400,000 ($1.4 million $1 million) on the sale of the land. The amount of the excess sale price of $600,000 ($2 million $1.4 million) is recognized as additional financing from Buyer to Seller (that is, Seller is receiving the additional benefit of financing from Buyer). Seller s incremental borrowing rate is 6 percent. The leaseback is classified as an operating lease At the commencement date, Seller derecognizes the land with a carrying amount of $1 million. Seller recognizes the cash received of $2 million, a financial liability for the additional financing obtained from Buyer of $600,000, and a gain on sale of the land of $400,000. Seller also recognizes a lease liability for the leaseback at the present value of the portion of the 10 contractual leaseback payments attributable to the lease of $38,479 ($120,000 contractual lease payment $81,521 of that lease payment that is attributable to the additional Buyer financing), discounted at the rate of 6 percent, which is $283,210, and a corresponding right-of-use asset of $283,210. The amount of $81,521 is the amount of each $120,000 annual payment that must be attributed to repayment of the principal of the financial liability for that financial liability to reduce to zero by the end of the lease term. 156 Technical Line A closer look at the new leases standard 31 March 2016

157 After initial recognition and measurement, at each period of the lease term, Seller will do both of the following: a. Decrease the financing obligation for the amount of each lease payment allocated to that obligation (that is, $81,521) and increase the carrying amount of the obligation for interest accrued using Seller s incremental borrowing rate of 6 percent. For example, at the end of Year 1, the balance of the financial obligation is $554,479 ($600,000 $81,521 + $36,000). b. Recognize the interest expense on the financing obligation (for example, $36,000 in Year 1) and $38,479 in operating lease expense At the end of the lease term, the financing obligation and the lease liability equal $ Also, at the commencement date, Buyer recognizes the land at a cost of $1.4 million and a financial asset for the additional financing provided to Seller of $600,000. Because the lease is an operating lease, at the date of sale Buyer does not do any accounting for the lease In accounting for the additional financing to Seller, Buyer uses 6 percent as the applicable discount rate, which it determined in accordance with paragraphs through Therefore, Buyer will allocate $81,521 of each lease payment to Buyer s financial asset and allocate the remaining $38,479 to lease income. After initial recognition and measurement at each period of the lease term, Buyer will do both of the following: a. Decrease the financial asset for the amount of each lease payment received that is allocated to that obligation (that is, $81,521) and increase the carrying amount of the obligation for interest accrued on the financial asset using Seller s incremental borrowing rate of 6 percent. Consistent with Seller s accounting, at the end of Year 1, the carrying amount of the financial asset is $554,479 ($600,000 $81,521 + $36,000). b. Recognize the interest income on the financing obligation (for example, $33,269 in Year 2) and $38,479 in operating lease income At the end of the lease term, the carrying amount of the financial asset is $0, and Buyer continues to recognize the land. 157 Technical Line A closer look at the new leases standard 31 March 2016

158 7.3 Transactions in which the transfer of an asset is not a sale Leases Sale and Leaseback Transactions Recognition If the transfer of the asset is not a sale in accordance with paragraphs through 25-3, both of the following apply: a. The seller-lessee shall not derecognize the transferred asset and shall account for any amounts received as a financial liability in accordance with other Topics. b. The buyer-lessor shall not recognize the transferred asset and shall account for the amounts paid as a receivable in accordance with other Topics. Initial Measurement The guidance in paragraph notwithstanding, the seller-lessee shall adjust the interest rate on its financial liability as necessary to ensure that both of the following apply: a. Interest on the financial liability is not greater than the principal payments on the financial liability over the shorter of the lease term and the term of the financing. The term of the financing may be shorter than the lease term because the transfer of an asset that does not qualify as a sale initially may qualify as a sale at a point in time before the end of the lease term. b. The carrying amount of the asset does not exceed the carrying amount of the financial liability at the earlier of the end of the lease term or the date at which control of the asset will transfer to the buyer-lessor (for example, the date at which a repurchase option expires if that date is earlier than the end of the lease term). If the transfer of an asset is not a sale, the seller-lessee and the buyer-lessor account for the transaction as a financing. The seller-lessee keeps the asset subject to the sale and leaseback transaction on its balance sheet and accounts for amounts received as a financial liability in accordance with other US GAAP. The seller-lessee decreases the financial liability by lease payments made, less the portion considered interest expense. The seller-lessee adjusts the interest rate on its financial liability as necessary to make sure that both: Interest on the financial liability is not greater than the principal payments on the financial liability over the shorter of the lease term or the term of the financing (i.e., there should be no negative amortization of the liability) The carrying amount of the asset does not exceed the carrying amount of the financial liability at the earlier of the end of the lease term or the date at which control of the asset will transfer to the buyer-lessor (i.e., there should be no built-in loss) If the transfer of the asset is not a sale, the buyer-lessor does not recognize the transferred asset and instead accounts for the amounts paid as a loan receivable in accordance with other US GAAP. 158 Technical Line A closer look at the new leases standard 31 March 2016

159 7.3.1 Example ASC 842 provides the following example of the accounting for a failed sale and leaseback transaction. Leases Sale and Leaseback Transactions Implementation Guidance and Illustrations Example 2 Accounting for Failed Sale and Leaseback Transaction An entity (Seller) sells an asset to an unrelated entity (Buyer) for cash of $2 million. Immediately before the transaction, the asset has a carrying amount of $1.8 million and has a remaining useful life of 21 years. At the same time, Seller enters into a contract with Buyer for the right to use the asset for 8 years with annual payments of $200,000 payable at the end of each year and no renewal options. Seller s incremental borrowing rate at the date of the transaction is 4 percent. The contract includes an option to repurchase the asset at the end of Year 5 for $800, The exercise price of the repurchase option is fixed and, therefore, is not the fair value of the asset on the exercise date of the option. Consequently, the repurchase option precludes accounting for the transfer of the asset as a sale. Absent the repurchase option, there are no other factors that would preclude accounting for the transfer of the asset as a sale Therefore, at the commencement date, Seller accounts for the proceeds of $2 million as a financial liability and continues to account for the asset. Buyer accounts for the payment of $2 million as a financial asset and does not recognize the transferred asset. Seller accounts for its financing obligation, and Buyer accounts for its financial asset in accordance with other Topics, except that, in accordance with paragraph , Seller imputes an interest rate (4.23 percent) to ensure that interest on the financial liability is not greater than the principal payments on the financial liability over the shorter of the lease term and the term of the financing and that the carrying amount of the asset will not exceed the financial liability at the point in time the repurchase option expires (that is, at the point in time Buyer will obtain control of the asset in accordance with the guidance on satisfying performance obligations in Topic 606). Paragraph does not apply to the buyer-lessor; therefore, Buyer recognizes interest income on its financial asset on the basis of the imputed interest rate determined in accordance with paragraphs through 25-13, which in this case Buyer determines to be 4 percent During Year 1, Seller recognizes interest expense of $84,600 (4.23% $2 million) and recognizes the payment of $200,000 as a reduction of the financial liability. Seller also recognizes depreciation expense of $85,714 ($1.8 million 21 years). Buyer recognizes interest income of $80,000 (4% $2 million) and recognizes the payment of $200,000 as a reduction of its financial asset At the end of Year 1, the carrying amount of Seller s financial liability is $1,884,600 ($2 million + $84,600 $200,000), and the carrying amount of the underlying asset is $1,714,286 ($1.8 million $85,714). The carrying amount of Buyer s financial asset is $1,880,000 ($2 million + $80,000 $200,000). 159 Technical Line A closer look at the new leases standard 31 March 2016

160 At the end of Year 5, the option to repurchase the asset expires, unexercised by Seller. The repurchase option was the only feature of the arrangement that precluded accounting for the transfer of the asset as a sale. Therefore, upon expiration of the repurchase option, Seller recognizes the sale of the asset by derecognizing the carrying amount of the financial liability of $1,372,077, derecognizing the carrying amount of the underlying asset of $1,371,429, and recognizing a gain of $648. Buyer recognizes the purchase of the asset by derecognizing the carrying amount of its financial asset of $1,350,041 and recognizes the transferred asset at that same amount. The date of sale also is the commencement date of the leaseback for accounting purposes. The lease term is 3 years (8 year contractual leaseback term 5 years already passed at the commencement date). Therefore, Seller recognizes a lease liability at the present value of the 3 remaining contractual leaseback payments of $200,000, discounted at Seller s incremental borrowing rate at the contractually stated commencement date of 4 percent, which is $555,018, and a corresponding right-of-use asset of $555,018. Seller uses the incremental borrowing rate as of the contractual commencement date because that rate more closely reflects the interest rate that would have been considered by Buyer in pricing the lease The lease is classified as an operating lease by both Seller and Buyer. Consequently, in Year 6 and each year thereafter, Seller recognizes a single lease cost of $200,000, while Buyer recognizes lease income of $200,000 and depreciation expense of $84,378 on the underlying asset ($1,350, years remaining useful life) At the end of Year 6 and at each reporting date thereafter, Seller calculates the lease liability at the present value of the remaining lease payments of $200,000, discounted at Seller s incremental borrowing rate of 4 percent. Because Seller does not incur any initial direct costs and there are no prepaid or accrued lease payments, Seller measures the right-of-use asset at an amount equal to the lease liability at each reporting date for the remainder of the lease term. 7.4 Lessee involvement in asset construction ( build-to-suit transactions) Leases Sale and Leaseback Transactions Implementation Guidance and Illustrations A lessee may obtain legal title to the underlying asset before that legal title is transferred to the lessor and the asset is leased to the lessee. If the lessee controls the underlying asset (that is, it can direct its use and obtain substantially all of its remaining benefits) before the asset is transferred to the lessor, the transaction is a sale and leaseback transaction that is accounted for in accordance with this Subtopic If the lessee obtains legal title, but does not obtain control of the underlying asset before the asset is transferred to the lessor, the transaction is not a sale and leaseback transaction. For example, this may be the case if a manufacturer, a lessor, and a lessee negotiate a transaction for the purchase of an asset from the manufacturer by the lessor, which in turn is leased to the lessee. For tax or other reasons, the lessee might obtain legal title to the underlying asset momentarily before legal title transfers to the lessor. In this case, if the lessee obtains legal title to the asset but does not control the asset before it is transferred to the lessor, the transaction is accounted for as a purchase of the asset by the lessor and a lease between the lessor and the lessee. 160 Technical Line A closer look at the new leases standard 31 March 2016

161 An entity may negotiate a lease before the underlying asset is available for use by the lessee. For some leases, the underlying asset may need to be constructed or redesigned for use by the lessee. Depending on the terms and conditions of the contract, a lessee may be required to make payments relating to the construction or design of the asset If a lessee incurs costs relating to the construction or design of an underlying asset before the commencement date, the lessee should account for those costs in accordance with other Topics, for example, Topic 330 on inventory or Topic 360 on property, plant, and equipment. Costs relating to the construction or design of an underlying asset do not include payments made by the lessee for the right to use the underlying asset. Payments for the right to use the underlying asset are lease payments, regardless of the timing of those payments or the form of those payments (for example, a lessee might contribute construction materials for the asset under construction) If the lessee controls the underlying asset being constructed before the commencement date, the transaction is accounted for in accordance with this Subtopic. Any one (or more) of the following would demonstrate that the lessee controls an underlying asset that is under construction before the commencement date: a. The lessee has the right to obtain the partially constructed underlying asset at any point during the construction period (for example, by making a payment to the lessor). b. The lessor has an enforceable right to payment for its performance to date, and the asset does not have an alternative use (see paragraph ) to the owner-lessor. In evaluating whether the asset has an alternative use to the owner-lessor, an entity should consider the characteristics of the asset that will ultimately be leased. c. The lessee legally owns either: 1. Both the land and the property improvements (for example, a building) that are under construction 2. The non-real-estate asset (for example, a ship or an airplane) that is under construction. d. The lessee controls the land that property improvements will be constructed upon (this includes where the lessee enters into a transaction to transfer the land to the lessor, but the transfer does not qualify as a sale in accordance with paragraphs through 25-3) and does not enter into a lease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements. 161 Technical Line A closer look at the new leases standard 31 March 2016

162 Judgment may be required to determine whether the lessee controls the underlying asset being constructed. e. The lessee is leasing the land that property improvements will be constructed upon, the term of which, together with lessee renewal options, is for substantially all of the economic life of the property improvements, and does not enter into a sublease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to sublease the land for substantially all of the economic life of the property improvements. The list of circumstances above in which a lessee controls an underlying asset that is under construction before the commencement date is not all inclusive. There may be other circumstances that individually or in combination demonstrate that a lessee controls an underlying asset that is under construction before the commencement date. ASC 840 provides guidance on when a lessee s involvement during the construction of an underlying asset makes the lessee, in substance, the owner of the asset during the construction period. Under ASC 840, if the lessee has substantially all of the construction-period risk, the lessee is deemed to be the accounting owner of the asset during construction and is subject to the sale and leaseback guidance at the completion of construction (generally when the lease commences). ASC 840 includes detailed quantitative and qualitative considerations for evaluating whether the lessee has substantially all of the construction-period risk. ASC 842 changes the focus to whether the lessee controls the asset being constructed rather than whether the lessee has substantially all of the risks during the construction period. As a result, under ASC 842, a lessee could reach a different conclusion about whether it is the accounting owner of an asset under construction than it does today for the same type of arrangement Determining whether the lessee controls the underlying asset being constructed In some cases, it is clear that the lessee controls the underlying asset being constructed (e.g., when the lessee legally owns the asset during the construction period). In other cases, it is clear the lessee does not control the underlying asset being constructed (e.g., when the lessee has little or no substantive involvement during construction). However, judgment may be required to determine whether the lessee s involvement, in substance, gives it control of the underlying asset. ASC 842 includes the following examples of circumstances that individually (or in the aggregate) demonstrate that the lessee controls an underlying asset that is under construction before the commencement date of a lease: The lessee has the right to obtain the partially constructed underlying asset at any point during the construction period. This right may be in the form of an option or obligation to purchase the asset from the lessor. The lessor has an enforceable right to payment for its performance to date, and the asset does not have an alternative use to the owner-lessor. In evaluating whether the asset has an alternative use to the owner-lessor, an entity should consider the characteristics of the asset that will ultimately be leased. The lessee legally owns the land and the property improvements (e.g., a building on the land) or the non-real estate asset (e.g., a ship) that is under construction. The lessee controls the land that property improvements will be constructed on and does not enter into a lease of the land before the beginning of construction that, together with renewal options, permits the lessor or another unrelated third party to lease the land for substantially all of the economic life of the property improvements. The lessee may control the land via legal ownership or, if it has transferred the land, in a transaction that does not qualify as a sale in accordance with ASC 842 (refer to section 7.3, Transactions in which the transfer of an asset is not a sale). 162 Technical Line A closer look at the new leases standard 31 March 2016

163 The lessee leases the land that the property improvements will be constructed on and the term of the lease (together with lessee renewal options) is for substantially all of the economic life of the property improvements, and the lessee does not sublease the land before the beginning of construction for the same time period (or longer) than the lessee controls the land. Judgment will be required to determine whether a lessee controls an asset under construction because this list is not all inclusive. For example, we believe that a lessee also controls an asset that is under construction if it funds substantially all of the costs of the materials needed for the construction project. ASC 842 provides the following examples of how to determine whether a lessee controls an underlying asset that is under construction. Leases Sale and Leaseback Transactions Implementation Guidance and Illustrations Example 3 Lessee Control over an Asset under Construction Lessee and Lessor enter into a contract whereby Lessor will construct (whether itself or using subcontractors) a building to Lessee s specifications and lease that building to Lessee for a period of 20 years once construction is completed for an annual lease payment of $1,000,000, increasing by 5 percent per year, plus a percentage of any overruns above the budgeted cost to construct the building. The building is expected to have an economic life of 50 years once it is constructed. Lessee does not legally own the building and does not have a right under the contract to obtain the building while it is under construction (for example, a right to purchase the construction in process from Lessor). In addition, while the building is being developed to Lessee s specifications, those specifications are not so specialized that the asset does not have an alternative use to Lessor. Case A Lessee Does Not Control the Asset under Construction Assume Lessee controls (that is, Lessee is the owner for accounting purposes) the land upon which the building will be constructed and, as part of the contract, Lessee agrees to lease the underlying land to Lessor for an initial period of 25 years. Lessor also is granted a series of six 5-year renewal options for the land lease None of the circumstances in paragraph exist. Even though Lessee owns the land (whether legally or for accounting purposes only) upon which the building will be constructed, Lessor legally owns the property improvements and has rights to use the underlying land for at least substantially all of the economic life of the building. Lessee does not own the building and does not have a right under the contract to obtain the building (for example, a right to purchase the building from Lessor). In addition, the building has an alternative use to Lessor. Therefore, Lessee does not control the building under construction. Consequently, the arrangement is not within the scope of this Subtopic. Lessee and Lessor will account for the lease of the building in accordance with Subtopics and , respectively. If Lessee incurs costs related to the construction or design of the building (for example, architectural services in developing the specifications of the building), it will account for those costs as lease payments unless the costs are for goods or services provided to Lessee, in which case Lessee will account for those costs in accordance with other Topics. 163 Technical Line A closer look at the new leases standard 31 March 2016

164 Case B Lessee Controls the Asset under Construction Assume Lessee leases, rather than owns, the land upon which the building will be constructed. Lessee has a 20-year lease of the underlying land and five 10-year renewal options. Therefore, Lessee s lease of the underlying land, together with the renewal options, is for at least substantially all of the economic life of the building under construction. Lessee enters into a sublease with Lessor for the right to use the underlying land for 20 years that commences upon completion of the building. The sublease has a single 10-year renewal option available to Lessor Lessee controls the building during the construction period and, therefore, the arrangement is within the scope of this Subtopic. Lessee and Lessor will apply the guidance in this Subtopic to determine whether this arrangement qualifies as a sale and a leaseback or whether this arrangement is, instead, a financing arrangement. Lessee controls the building during the construction period because, in accordance with paragraph (e), Lessee controls the use of the land upon which the building will be constructed for a period that is at least substantially all of the economic life of the building and the sublease entered into with Lessor does not both (a) grant Lessor the right to use the land before the beginning of construction and (b) permit Lessor to use the land for substantially all the economic life of the building (that is, the sublease, including Lessor renewal options, only is for 30 years as compared with the 50-year economic life of the building) Accounting when the lessee does not control the underlying asset being constructed If the lessee does not control the underlying asset being constructed, any payments made for the right to use the underlying asset are lease payments, regardless of the timing or form of those payments (e.g., the lessee could provide some of the raw materials for use in construction). Lease payments made prior to lease commencement are recognized as a prepaid asset and evaluated in the lease classification test. Costs incurred by the lessee that relate specifically to construction or design of an asset that are not payments for the use of an asset to be leased are recognized in accordance with other US GAAP (e.g., ASC 330 Inventory, ASC 360) Accounting when the lessee controls the underlying asset being constructed ASC 842 does not provide specific recognition and measurement guidance for a lessee that controls an asset being constructed. In that case, we believe that the asset is recognized during the construction period as costs are incurred to construct the asset. A liability also should be recognized in an amount equal to the capitalized costs that are not paid for by the lessee (e.g., paid for by the lessor). However, consistent with the application of ASC 840, if the lessee controls the asset during the construction period, a sale and leaseback of the asset occurs at the completion of construction (generally when the lease commences). The sale and leaseback guidance in ASC 842 is evaluated to determine whether the underlying asset is derecognized. If the application of the sale and leaseback guidance results in a failed sale, the asset remains on the lessee s balance sheet and the liability is subsequently accounted for as a financing obligation. 164 Technical Line A closer look at the new leases standard 31 March 2016

165 How we see it We believe that, under ASC 842, fewer lessees will determine that they are the accounting owner of assets being constructed than is the case under ASC 840. As a result, fewer lessees will be required to evaluate the sale and leaseback guidance in ASC 842 for assets that are constructed Transition ASU includes transition provisions for assets and liabilities that are on the balance sheet solely as a result of the application of ASC 840 s build-to-suit guidance. Refer to section 9.3.5, Lessee involvement in asset construction ( build-to-suit transactions). 7.5 Disclosure Leases Sale and Leaseback Transactions Disclosure If a seller-lessee or a buyer-lessor enters into a sale and leaseback transaction that is accounted for in accordance with paragraphs and through 30-3, it shall provide the disclosures required in paragraphs through 50-9 for a seller-lessee or paragraphs through for a buyer-lessor In addition to the disclosures required by paragraphs through 50-9, a seller-lessee that enters into a sale and leaseback transaction shall disclose both of the following: a. The main terms and conditions of that transaction b. Any gains or losses arising from the transaction separately from gains or losses on disposal of other assets. A seller-lessee that enters into a sale and leaseback transaction in which the transfer of the asset is a sale is required to provide disclosures applicable to lessees (refer to section 4.8, Disclosure). Similarly, a buyer-lessor that enters into a sale and leaseback transaction in which the transfer of the asset is a purchase is required to provide disclosures applicable to lessors (refer to section 5.9, Disclosure). A seller-lessee in a sale and leaseback transaction is also required to disclose: The main terms and conditions of the transaction Any gains or losses arising from the transaction separately from gains or losses on the disposal of other assets How we see it ASC 842 does not include specific disclosure requirements for transactions that are accounted for as financings. We believe that entities would apply other US GAAP (e.g., ASC 820) to make the appropriate disclosures. 165 Technical Line A closer look at the new leases standard 31 March 2016

166 8 Business combinations 8.1 Classification of acquired leases Master Glossary Acquiree The business or businesses that the acquirer obtains control of in a business combination. This term also includes a nonprofit activity or business that a not-for-profit acquirer obtains control of in an acquisition by a not-for-profit entity. Acquirer The entity that obtains control of the acquiree. However, in a business combination in which a variable interest entity (VIE) is acquired, the primary beneficiary of that entity always is the acquirer. Acquisition by a Not-for-Profit Entity The acquiring entity in a business combination does not change the acquiree s existing lease classification unless the lease is modified. A transaction or other event in which a not-for-profit acquirer obtains control of one or more nonprofit activities or businesses and initially recognizes their assets and liabilities in the acquirer s financial statements. When applicable guidance in Topic 805 is applied by a not-for-profit entity, the term business combination has the same meaning as this term has for a for-profit entity. Likewise, a reference to business combinations in guidance that links to Topic 805 has the same meaning as a reference to acquisitions by not-for-profit entities. Business Combination A transaction or other event in which an acquirer obtains control of one or more businesses. Transactions sometimes referred to as true mergers or mergers of equals also are business combinations. See also Acquisition by a Not-for-Profit Entity. Implementation Guidance and Illustrations Lease of an Acquiree In a business combination or an acquisition by a not-for-profit entity, the acquiring entity should retain the previous lease classification in accordance with this Subtopic unless there is a lease modification and that modification is not accounted for as a separate contract in accordance with paragraph Under ASC 842, the acquiring entity in a business combination or acquisition by a not-for-profit entity does not change the acquiree s existing lease classification unless the lease is modified and is not accounted for as a separate contract. If a lease is modified, and the modified lease is accounted for as a separate contract, the acquirer classifies the new lease based on ASC 842 s lease classification guidance. An unmodified lease is accounted for in accordance with the guidance in the remainder of this section. Refer to section 4.5, Lease modifications, and section 5.6, Lease modifications, for a discussion of lessee and lessor modifications, respectively. 166 Technical Line A closer look at the new leases standard 31 March 2016

167 8.2 Initial recognition Business combinations Identifiable Assets and Liabilities, and Any Noncontrolling Interest Recognition The acquirer shall recognize separately from goodwill the identifiable intangible assets acquired in a business combination. An intangible asset is identifiable if it meets either the separability criterion or the contractual-legal criterion described in the definition of identifiable. Additional guidance on applying that definition is provided in paragraphs through 25-15, through 55-45, and Example 1 (see paragraph ). For guidance on the recognition and subsequent measurement of a defensive intangible asset, see Subtopic A An identifiable intangible asset may be associated with a lease, which may be evidenced by market participants willingness to pay a price for the lease even if it is at market terms. For example, a lease of gates at an airport or of retail space in a prime shopping area might provide entry into a market or other future economic benefits that qualify as identifiable intangible assets, such as a customer relationship. In that situation, the acquirer shall recognize the associated identifiable intangible asset(s) in accordance with paragraph Regardless of whether the acquiree is the lessee or the lessor, the acquirer shall determine whether the terms of each of an acquiree s operating leases are favorable or unfavorable compared with the market terms of leases of the same or similar items at the acquisition date. If the acquiree is a lessor, the acquirer shall recognize an intangible asset if the terms of an operating lease are favorable relative to market terms and a liability if the terms are unfavorable relative to market terms. If the acquiree is a lessee, the acquirer shall adjust the measurement of the acquired right-of-use asset for any favorable or unfavorable terms in accordance with paragraph A The acquirer shall recognize assets and liabilities arising from leases of an acquiree in accordance with Topic 842 on leases (taking into account the requirements in paragraph (a)) B For leases for which the acquiree is a lessee, the acquirer may elect, as an accounting policy election by class of underlying asset and applicable to all of the entity s acquisitions, not to recognize assets or liabilities at the acquisition date for leases that, at the acquisition date, have a remaining lease term of 12 months or less. This includes not recognizing an intangible asset if the terms of an operating lease are favorable relative to market terms or a liability if the terms are unfavorable relative to market terms. 167 Technical Line A closer look at the new leases standard 31 March 2016

168 The acquirer separately recognizes identifiable intangible assets associated with the inherent value of the lease (i.e., the price market participants are willing to pay for an at-market lease). For a lessor, the inherent value may relate to the economic benefit of acquiring an asset with an in-place lease versus one that is not leased. An intangible asset is identifiable if it meets either the separability criterion or the contractual-legal criterion as described further in section 4.2.5, Intangible assets, of our Financial reporting developments publication, Business combinations. The following table summarizes how the acquirer in a business combination accounts for leases with terms that are favorable or unfavorable relative to market terms at the business combination date. Operating lease Finance lease (lessees) Sales-type or direct financing lease (lessors) Acquiree in a business combination is a lessee The value of any off-market terms of a lease are reflected in the initial measurement of the right-of-use asset. That is, the acquirer does not separately recognize an intangible asset or a liability for the off-market terms of a lease. Refer to section 8.3.1, Acquiree in a business combination is a lessee in a finance or operating lease. Not applicable Acquiree in a business combination is a lessor The value of any off-market terms of a lease are separately recognized as an intangible asset or a liability. Refer to section 8.3.3, Acquiree in a business combination is a lessor in an operating lease. Not applicable The value of any off-market terms of a lease is included in the measurement of the acquisition date fair value of the underlying asset that is used to determine the unguaranteed residual asset. That is, the acquirer does not separately recognize an intangible asset for the off-market terms of a lease. Refer to section 8.3.2, Acquiree in a business combination is a lessor in a sales-type or direct financing lease. Leases with a remaining lease term of 12 months or less If the acquiree is a lessee, the acquirer may make an accounting policy election by class of underlying asset for all business combinations to not recognize assets and liabilities for leases that at the acquisition date have a remaining lease term of 12 months or less. This includes not recognizing an intangible asset if the terms of an operating lease are favorable relative to market terms or a liability if the terms are unfavorable relative to market terms. 168 Technical Line A closer look at the new leases standard 31 March 2016

169 8.3 Initial and subsequent measurement Acquiree in a business combination is a lessee in a finance or operating lease Business combinations Identifiable Assets and Liabilities, and Any Noncontrolling Interest Initial Measurement For leases in which the acquiree is a lessee, the acquirer shall measure the lease liability at the present value of the remaining lease payments, as if the acquired lease were a new lease of the acquirer at the acquisition date. The acquirer shall measure the right-of-use asset at the same amount as the lease liability as adjusted to reflect favorable or unfavorable terms of the lease when compared with market terms. Subsequent Measurement Leasehold improvements acquired in a business combination shall be amortized over the shorter of the useful life of the assets and the remaining lease term at the date of the acquisition. However, if the lease transfers ownership of the underlying asset to the lessee, or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee shall amortize the leasehold improvements to the end of their useful life. When the acquiree in a business combination is a lessee, the acquirer initially measures the lease liability for acquired finance and operating leases as if the leases are new at the acquisition date. As a reminder, in a business combination or acquisition by a not-for-profit, the acquiring entity does not change the acquiree s existing lease classification unless the lease is modified and the modified lease is not accounted for as a separate contract. The FASB indicated in the Basis for Conclusions (BC 415) that measuring the acquired lease as if it were a new lease includes assessing the following: The lease term Any lessee options to purchase the underlying asset Lease payments The discount rate for the lease The lease liability is measured at the present value of the remaining lease payments using the concepts described in chapter 2, Key concepts, to determine the lease term, lease payments and discount rate as of the acquisition date. The right-of-use asset is measured at an amount equal to the lease liability, adjusted for favorable or unfavorable terms of the lease when compared with market terms. The acquirer does not separately recognize an intangible asset or liability for favorable or unfavorable lease terms relative to market terms. However, the acquirer separately recognizes any other identifiable intangible assets associated with the lease, which may be evidenced by market participants willingness to pay for the lease even if it is at market terms. For example, ASC A indicates that a lease of gates at an airport or a lease of retail space in a prime shopping area might provide entry into a market or other future economic benefits that qualify as an intangible asset. 169 Technical Line A closer look at the new leases standard 31 March 2016

170 The subsequent measurement of an acquired lease liability and right-of-use asset is determined using the lessee subsequent measurement guidance under ASC 842. Refer to chapter 4, Lessee accounting. The acquirer also recognizes leasehold improvements acquired in a business combination at fair value in accordance with ASC 805 and amortizes the assets over the shorter of the useful life of the assets or the remaining lease term at the date of acquisition. However, if the lease transfers ownership of the underlying asset to the lessee, or the lessee is reasonably certain to exercise an option to purchase the underlying asset, the lessee amortizes the leasehold improvements to the end of their useful life Acquiree in a business combination is a lessor in a sales-type or direct financing lease Business combinations Identifiable Assets and Liabilities, and Any Noncontrolling Interest Initial Measurement For leases in which the acquiree is a lessor of a sales-type lease or a direct financing lease, the acquirer shall measure its net investment in the lease as the sum of both of the following (which will equal the fair value of the underlying asset at the acquisition date): a. The lease receivable at the present value, discounted using the rate implicit in the lease, of the following, as if the acquired lease were a new lease at the acquisition date: 1. The remaining lease payments 2. The amount the lessor expects to derive from the underlying asset following the end of the lease term that is guaranteed by the lessee or any other third party unrelated to the lessor. b. The unguaranteed residual asset as the difference between the fair value of the underlying asset at the acquisition date and the carrying amount of the lease receivable, as determined in accordance with (a), at that date. The acquirer shall take into account the terms and conditions of the lease in calculating the acquisition-date fair value of an underlying asset that is subject to a sales-type lease or a direct financing lease by the acquiree-lessor. As a reminder, in a business combination or acquisition by a not-for-profit entity, the acquiring entity does not change the acquiree s existing lease classification unless the lease is modified and the modified lease is not accounted for as a separate contract. When the acquiree in a business combination is a lessor in a sales-type or direct financing lease, the acquirer measures the lease receivable as if the lease is new at the acquisition date. This includes assessing the lease term, any lessee options to purchase the underlying asset, lease payments and the discount rate for the lease. The acquirer measures the lease receivable at the present value of the remaining lease payments and any guaranteed residual asset, using the concepts described in chapter 2, Key concepts, to determine the lease term, lease payments and discount rate. 170 Technical Line A closer look at the new leases standard 31 March 2016

171 The unguaranteed residual asset is initially measured as the difference between the acquisition date fair value of the underlying asset and the lease receivable (as determined above) on that date. The acquirer takes into consideration the terms and conditions of the lease (e.g., off-market terms) when calculating the acquisition date fair value of the underlying asset. That is, the value of any off-market terms of the lease is included in the measurement of the acquisition date fair value of the underlying asset that is used to determine the unguaranteed residual asset (i.e., while ASC 805 refers to the acquisition date fair value of the underlying asset, this estimated amount does not represent fair value in accordance with ASC 820 because, in this case, the fair value is adjusted for any off-market terms of the lease associated with the underlying asset). An acquirer also recognizes other identifiable intangible assets (e.g., the value associated with an in-place lease) separately from the net investment in the lease. The subsequent measurement of the net investment in a sales-type or direct financing lease is determined using the lessor subsequent measurement guidance under ASC 842. Refer to chapter 5, Lessor accounting Acquiree in a business combination is a lessor in an operating lease As a reminder, in a business combination or acquisition by a not-for-profit entity, the acquiring entity does not change the acquiree s existing lease classification unless the lease is modified and the modified lease is not accounted for as a separate contract. Underlying assets subject to operating leases remain on the lessor s balance sheet. Therefore, when an acquiree is a lessor, an underlying asset subject to an operating lease is recognized on the acquirer s balance sheet and initially measured at its acquisition date fair value in accordance with ASC 805. The acquirer recognizes an intangible asset if the terms of an operating lease are favorable compared with market terms and a liability if the terms are unfavorable compared with market terms. The acquiree also separately recognizes identifiable intangible assets associated with the inherent value of the lease (i.e., the price market participants are willing to pay for an at-market lease). The subsequent measurement of the underlying asset subject to an operating lease is determined under ASC 360. After the business combination, the acquirer follows the accounting for any operating lease as described in section 5.4, Operating leases. 171 Technical Line A closer look at the new leases standard 31 March 2016

172 9 Effective date and transition 9.1 Effective date Leases Overall Transition and Open Effective Date Information The following represents the transition and effective date information related to Accounting Standards Update No , Leases (Topic 842): a. A public business entity, a not-for-profit entity that has issued or is a conduit bond obligor for securities that are traded, listed, or quoted on an exchange or an over-the-counter market, and an employee benefit plan that files or furnishes financial statements with or to the U.S. Securities and Exchange Commission shall apply the pending content that links to this paragraph for financial statements issued for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Earlier application is permitted. The new guidance is effective for public business entities for annual periods beginning after 15 December b. All other entities shall apply the pending content that links to this paragraph for financial statements issued for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, Earlier application is permitted. ASU is effective for annual periods beginning after 15 December 2018 (i.e., 1 January 2019 for a calendar-year entity), and interim periods within those years, for PBEs and both of the following: Not-for-profit entities that have issued, or are conduit bond obligors for, securities that are traded, listed or quoted on an exchange or an over-the-counter market Employee benefit plans that file or furnish financial statements with or to the SEC For all other entities, ASU is effective for annual periods beginning after 15 December 2019 (i.e., 1 January 2020 for a calendar-year entity), and interim periods beginning after 15 December 2020 (i.e., 1 January 2021 for a calendar-year entity). Early adoption is permitted for all entities Disclosure prior to adoption Entities subject to SEC reporting requirements should provide disclosures about the effects of ASU in registration statements and periodic reports filed with the SEC. As noted in SEC Staff Accounting Bulletin Topic 11.M, 5 the SEC staff expects disclosure of the potential effects of new standards if they are known. These entities should consider making the following disclosures within MD&A and the financial statements: A brief description of the new standard, the date that adoption is required and the date that the registrant plans to adopt, if earlier A discussion of the method of adoption allowed, including whether the optional practical expedients will be applied (refer to section 9.2.2, Practical expedients) 5 SAB Topic 11.M, Disclosure Of The Impact That Recently Issued Accounting Standards Will Have On The Financial Statements Of The Registrant When Adopted In A Future Period. 172 Technical Line A closer look at the new leases standard 31 March 2016

173 A discussion of the effect the standard is expected to have on the financial statements or, if the effect isn t known or reasonably estimable, a statement to that effect Disclosure of other significant matters that the entity believes might result from adopting the standard (e.g., planned or intended changes in business practices) How we see it An SEC reporting entity may not initially have the ability to make a reasonable estimate of the effect the new standard will have on its financial statements and will make a statement to that effect. For example, a company may state the following: In February 2016, the FASB issued guidance codified in ASC 842, Leases, which supersedes the guidance in ASC 840, Leases. Footnote XX provides details on the Company s current lease arrangements. While the Company is currently evaluating the provisions of ASC 842 to determine how it will be affected, the primary effect of adopting the new standard will be to record assets and obligations for current operating leases. The SEC staff has said it expects an entity s disclosures to evolve in each reporting period as more information about the effects of a new standard becomes available Adoption of ASU before the adoption of the new revenue recognition standard Because early adoption is permitted, an entity may adopt ASU before it adopts the new revenue recognition standard (ASU , primarily codified in ASC 606). The FASB aligned several concepts in ASC 842 with concepts in ASC 606 (e.g., determining whether the transfer of an asset is a sale in a sale and leaseback transaction) and in some cases required lessors to apply specific guidance in ASC 606 to their leasing transactions (e.g., for a lessor s allocation of the consideration in the contract). Therefore, an entity that adopts the new leasing guidance before it adopts the new revenue guidance may need to apply certain concepts in ASC 606 in accounting for the leases. 9.2 Transition Leases Overall Transition and Open Effective Date Information c. In the financial statements in which an entity first applies the pending content that links to this paragraph, the entity shall recognize and measure leases within the scope of the pending content that links to this paragraph that exist at the beginning of the earliest comparative period presented, using the approach described in (i) through (ee). d. An entity shall adjust equity at the beginning of the earliest comparative period presented, and the other comparative amounts disclosed for each prior period presented in the financial statements, as if the pending content that links to this paragraph had always been applied, subject to the requirements in (h) through (dd). e. If a lessee elects not to apply the recognition and measurement requirements in the pending content that links to this paragraph to short-term leases, the lessee shall not apply the approach described in (k) through (s) to short-term leases. See Examples 28 through 29 (paragraphs through ) for illustrations of the transition requirements. 173 Technical Line A closer look at the new leases standard 31 March 2016

174 ASU s transition provisions are applied as of the beginning of the earliest comparative period presented in the financial statements (i.e., the date of initial application). As illustrated below, a calendar-year entity that adopts ASU on 1 January 2019 and presents three-year comparative financial statements applies the transition provisions on 1 January 2017 (i.e., the beginning of the earliest comparative period presented). An entity should also apply ASC 842 s disclosure requirements for each prior period presented as applicable. Lessees and lessors are required to adopt ASU using a modified retrospective approach. * Public entities include PBEs and certain not-for-profit entities and employee benefit plans Lessees that make an accounting policy election (by class of underlying asset to which the right of use relates) to apply the short-term lease exception do not apply the lessee transition provisions discussed in section 9.3, Lessee transition, to qualifying leases. Refer to section 4.1.1, Short-term leases, for a discussion of identifying a short-term lease. Lessees and lessors are required to adopt ASU using a modified retrospective approach for all leases that exist at or commence after the date of initial application with an option to use certain practical expedients (refer to section 9.2.2, Practical expedients). Lessees and lessors are prohibited from using a full retrospective transition approach. The FASB indicated in the Basis for Conclusions (BC 391) that applying a modified retrospective transition approach will not produce the same accounting result as a full retrospective approach but the results will be similar and that the benefits of a more precise transition approach would not justify the costs SEC reporting considerations Entities subject to SEC reporting requirements will have to consider how to present information in the selected financial data table. 6 When a new standard is adopted retrospectively, the SEC staff s longstanding view has been that all periods in the five-year table must be recast to give effect to the retrospective adoption of a new accounting standard. We understand that the presentation of information in the selected financial data table for the new leases standard is the subject of discussions with the SEC staff. We will update this publication when more information becomes available. 6 Item 301 of Regulation S-K. 174 Technical Line A closer look at the new leases standard 31 March 2016